Understanding the Dow Jones

This question—What did the Market do today?—is one we hear often at Moneta Group, but I think what people are actually asking is, ‘What did the Dow Jones do today?’ For most people, the Dow Jones is just a number—plus or minus for the day—that tells them the market went up or down. But what is the Dow Jones really?

To help explain, it’s key to note that the GM bankruptcy and Citigroup price decline led the Dow to “reshuffle” its index this week: GM and Citigroup are out and Travelers and Cisco are in. Because of those changes, this is a perfect time to explore the question of ‘What is the Dow,’ as well as to examine the Dow’s relevance as a major market barometer moving forward.

The Dow Jones Industrial Index is made up of 30 of the largest U.S. stocks.   Those 30 stocks are selected by the Dow Jones Co., and the most recent change—GM and Citigroup outTravelers and Cisco in—marks the third time in the past two years that a change has been made in the stocks that are included.  The stocks within the index are not equal weighted (they are not simply 1/30 of the total). The index is price-weighted, with weightings calculated based on owning 1 share of stock in all 30 companies in the list.

The result of this ‘weighting’ is that the percentage that one component of the Dow comprises is not determined by the company’s size, but instead by the price of its stock.  For example, IBM is trading north of $100 per share, and as a result it makes up about 10 percent of the Dow.  This is more of a ‘weighting’ than Alcoa, Bank of America, GE, Intel, Microsoft and Pfizer combined.  So that begs the question, is this really a good representation of the “market”?

Maybe there are other indicators that are just as important when asking about the day’s market performance. Apart from being comprised of 30 stocks vs. 500 stocks in the S&P, the major difference between the two ind is how they weight the components.  While the Dow is price weighted, the S&P is weighted by market cap or size of the company.

So the next time you ask how the market is doing, rather than looking at the Dow’s skewed weightings, a look at the S&P 500 may give you a more complete picture.

Patrick McGinnis, CFA, CFP®

Patrick is the professional consultant for Don Kukla and Peter Schick.

Additional articles