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Street view of the New York Stock Exchange building at sunset.

When you want to know how the U.S. economy is doing, a major component to look at is the movement of the Dow Jones Industrial Average, otherwise known as the Dow. It’s one of the poster boys of financial metrics. The Dow’s up or down fluctuations are reported not only by investment nerds, but by mainstream news outlets as well.

But what exactly is the Dow and why has it attained such prominence? What’s the difference between the Dow and other indexes like the S&P 500 and the Nasdaq composite, which are also reported on daily? This post aims to answer these questions and more.

What Is the Dow?

The Dow tracks 30 of the largest publicly traded companies on either the New York Stock Exchange (NYSE) or the Nasdaq. Its purpose is to give investors and the public at large an idea of the direction of the stock market at a glance. An explanation of the sheer size of the stock market will give you an idea of why such a barometer is needed. Here are a couple of statistics.

There are currently 2,400 companies being bought and sold on the NYSE across a wide spectrum of industries and each faces its own challenges and opportunities.

These companies routinely trade over 3 billion shares worth of volume on a daily basis. While some boom, others face hard times. Therefore, it’s difficult to glean any information about the state of our economy based on the performance of one company.

With that in mind, at the turn of the 20th century, Wall Street Journal founder and financial luminary Charles Dow dreamed up a measurement that could be used to provide investors with a reasonable indicator for how the stock market was performing as a whole. The Dow was born and was originally comprised of 12 of the country’s largest companies, mainly railroads and industrial companies, hence the name Dow Jones Industrial Average. The daily performance of these companies’ stock prices were tabulated, averaged and then published for investors.

Unlike the latter part of the 19th century, the stocks that comprise the Dow are not all heavy industrial companies. The fact that we still refer to it as the Dow Jones Industrial Average is simply an homage to its roots. However, there are several other, more industry-specific indices that are used as performance indicators for certain sectors of the economy, like utilities, transportation and software.

What Companies Are in the Dow?

Today, the Dow consists of 30 large American companies representing various industries, from telecommunications to energy production.

We won’t go through them all here, but the Dow includes technology stalwarts like Apple, Microsoft, Intel, IBM, Nike, Coca-Cola and McDonald’s. Disney is on there representing the entertainment industry.

The oil industry has a big presence, with the appearance of both Chevron and Exxon Mobil. Pfizer, Procter & Gamble and Merck are all listed as well.

How Is It Calculated and What Does It Mean?

The stock prices of these companies are added together and then divided by what’s referred to as the “Dow Divisor.” The Dow Divisor attempts to account for things like stock splits that would change the price of a component stock and fundamentally change the value of the index itself. Think about it: A stock split halves the value of a stock, but you get twice the amount of stock. It’s not that the value of the company fell by 50%.

Once the stock prices are added together and divided by the Dow Divisor, what you’re left with is an average value that serves as a barometer for how the entire stock market is doing.

If these companies do well, the Dow goes up. If the results are mixed, it stays flat. If these companies are having a rough time, the Dow falls. If the largest companies representing a mix of industries are having good or bad days, it’s not a difficult assumption to make that smaller companies within that industry are probably faring the same.

Typically, when the change in the Dow is reported, you’ll see a number and a percentage. The number indicates the average value of these companies combined, compared to the opening price for the day. The percentage indicates how large that number is in relation to their total value.

As I write this article, the Dow is +60.14 points (0.23%). That means that the value of the companies in the index is up by more than 60 points, or around 0.23% of their total value.

Criticisms of the Dow

There’s a reason why the Dow is still around over 130 years after it was created. But it’s not without its criticisms.

Just like any average or index, it’s only as good as the sum of its parts. Some economists believe that you cannot paint an accurate picture of how the economy is functioning by using just 30 companies.

The Dow also has a way of over-representing the importance of the companies that comprise it. Let’s say McDonald’s, for example, is embroiled in a lawsuit that has investors scared. The value of the company would drop, which would affect the value of the Dow as a whole. But, if Wendy’s and Burger King are having great days and selling lots of burgers, McDonald’s case would be an anomaly and not reflective of the fast food industry, or the economy as a whole.

The bottom line is that the stock market and economy are both incredibly complex. It’s impossible to quickly determine its health using just one number, but the Dow does just that. Criticisms aside, it’s used by economists and financial institutions around the world and is likely to stay a leading economic indicator for America.

Comparison to Other Market Indicators

Despite its status as a major bellwether of the market as a whole, the Dow is far from the only market number that’s regularly reported on and tracked by market participants and the public at large. Let’s see how the Dow compares to two other figures that receive a lot of attention.

What Is the Difference Between the S&P 500 and the Dow?

The main business of the S&P 500 is providing credit ratings that investors can use as one tool to decide whether a company is worthy of their investment. However, most people know it for its index of 500 large American companies. As such, it represents a much broader swath of the overall economy than the 30 companies in the Dow.

Unlike the Dow, companies are weighted in the index according to the market capitalization of the company. A company with a large capitalization like Apple has a larger impact on the index than a (relatively) smaller company like Mattel.

What Is the Difference Between the Dow and the Nasdaq?

Depending on how you look at the Nasdaq, there’s both a big difference and not much difference at all between it and the Dow. How can that be? When people refer to the Nasdaq, they could be referring to a couple of different things.

In one sense, the Nasdaq serves as another index for stock trading, a competitor to the NYSE. Traders buy and sell stock on the index. One of the major differences between the Nasdaq and the NYSE – in addition to the companies listed – is that unlike the NYSE where there’s a physical trading floor, all trading orders on the Nasdaq are submitted electronically and transmitted over a high-speed network.

In addition to the differences in trading style, the Nasdaq tends to attract more tech-focused companies, including Apple, Microsoft and Alphabet (Google’s parent company). Although not a hard and fast rule, the NYSE is home to a greater number of companies from long-established industries including Caterpillar, Johnson & Johnson and McDonald’s.

On the other hand, the Nasdaq is very much like the Dow and S&P 500 in the sense that the number you see reported throughout the trading day is a composite. The stock valuation for each company on the market is tallied, but then the companies are weighted by market cap similarly to the S&P 500.

Want to learn more? Learn the basics of how the markets work and whether you should start investing, courtesy of the Zing Blog!

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