How Does the Dow Jones Work?

• The Dow Jones is a type of stock market index that was created by an editor of the Wall Street Journal and the co-founder of the Dow Jones Company. Although it’s complicated, it’s important to understand it, particularly if you are considering investing your money.

When it was first launched, it was calculated by taking the price of one share of each of the company’s stock, adding all the numbers together, and dividing by the number of companies in the Dow Jones.

However, although that is still the basic premise of the Dow Jones, there is now a more complicated formula to determine it. This formula adjusts for companies that are added or removed, or for things such as stock splits. A stock split occurs when a company doubles the number of their stocks and then splits the price of each stock in half.

The formula is also meant to keep the index consistent over time. For example, the index today should be able to be compared to the index thirty years from now or the index from ten years ago. One way that the Dow Jones is able to keep the index relevant and consistent is by changing the divisor.

The divisor is the number that is divided into the total number of stock prices (the number that was twelve when the index first started). As of April 2010, the advisor is 0.122820114.

What Is the Dow Jones?

The Dow Jones is actually short for the Dow Jones Industrial Average (also known as the DJIA). It’s the oldest, continuing and the most famous United States’ market index, which was later joined by newer indexes such as the NASDAQ. It measures the combined stock value of over thirty large United States companies.

The Companies On the Dow

It began with only twelve companies. It originally included companies that no longer exist or have been removed from the index, such as:

• United States Leather Company
• Tennessee Coal, Iron and Railroad Company
• American Tobacco Company
• American Cotton Oil Company
• Distilling & Cattle Feeding Company
• Laclede Gas Company
• National Lead Company

It was started by Charles Dow on May 26, 1986. It represented the dollar average of the twelve stocks of leading American industries. The only remaining stock that is still in the Dow Jones Index is General Electric.

Today, the Dow Jones has moved away from only including industry leaders and the companies on the Dow Jones now include financial companies and technology companies, such as Citigroup and IBM respectively. When the index was first published, it stood at a level of 40.94. During the summer of 1896, it hit an all time low of 28.48. This was later referred to as the Panic of 1896.

Calculating the Index

One of the biggest difficulties of calculating the index is that certain aspects of the index make up larger parts than other companies in the index. The Dow Jones adjusts for this by using a price weighted average. This price weighted average means that expensive stocks have more influences over the index number than less expensive stock prices do.

Since the index is based on the dollar number value of the stocks (along with the formula, and the divisor), if a higher stock increase by ten percent and a lower stock increases by ten percent, there would be a greater dollar increase for the higher stock.

The same is true if the higher stocks fall in price verses when the lower stocks fall in price. Thus, the price weighted average ensures that one stock won’t pull the index up too high or one stock won’t pull the index down too far. The Dow Jones is supposed to be a representation of all the thirty companies in the index, and thus one company should not have significantly more weight than another company in the index.