How Well Do You Know the Dow Jones Industrial Average?

Over the 119-year Dow Jones Industrial Average history, the index has become synonymous with the markets. Most investors check on the DJIA at the end of every trading day, if not more frequently.

But how much do investors really know about the index they rely on?

Other than that it contains 30 blue-chip stocks, few investors give much thought to how the DJIA came about or why it's structured the way it is. And yet the Dow Jones Industrial Average history is key to understanding what the index is really telling us every day.

Here are five important Dow facts that show how this powerful index came to be the world's most widely tracked measure of stocks...

Dow Jones Industrial Average: 5 Must-Know Facts

Dow History: The DJIA was the first index.

Dow Jones Industrial AverageBefore Charles Dow created the DJIA in 1896, investors had no way of identifying trends in the overall market. Was it a bull market or a bear market? No one knew. There was no way to tell.

Charles Dow wanted to summarize the stock market with one easy-to-grasp number. He did this by selecting the 12 stocks he felt best represented the American economy at the time.

Today it's hard to imagine what a breakthrough this was. But imagine trying to follow the markets without any market indexes!

By giving investors a simple, reliable, and consistent tool for measuring market movements, Dow actually changed investing. Knowing the overall trends helped investors make better decisions. Thanks, Charles Dow!

Dow History: There's a good reason the DJIA has only 30 stocks.

As noted above, the Dow Jones Industrial Average debuted with 12 stocks [get that list - and where those companies are now - here]. It expanded to 20 stocks in 1916 and to 30 stocks in 1928, presumably reflecting the rapid growth in the U.S. economy. But the U.S. economy has grown vastly larger since 1928. Why don't we have 50 DJIA stocks, or 75, or 100?

In fact, the Averages Committee, which makes decisions on the components of the Dow, several years ago considered increasing the roster to 50 stocks. It chose to keep the number at 30.

"The number of stocks is not nearly as important as the ones we pick," the S&P Dow Jones Indices company explains on its website. "The Dow could have 50 or 100 components, but unless the mix was right it would not work as a market barometer."

"Getting the mix right" is also why Dow Jones Industrial Average stocks are chosen by humans, and not defined by a class of data such as market capitalization.

Which brings us to the next quirk of the DJIA...

Dow History: The Dow Jones is not really an average.

Although the word "average" is in the name, the Dow is really an index. What Charles Dow did was an average, but that changed in 1928 when the DJIA expanded to 30 stocks from 20.

To maintain price continuity, the Dow divisor was born. It prevents any change, whether it's a change in the components or a stock split, from affecting the index. Each such change requires a new Dow divisor.

The first divisor in 1928 was 16.67. The current divisor, to accommodate the March 19 addition of Apple, is 0.14859.

Dow History: The Dow Jones Industrial Average is price-weighted.

While not often discussed, the influence of each Dow Jones stock on the index depends on its price. Most other indexes weight by market cap.

The most expensive DJIA stocks move the index far more than the least expensive. The current stock with the highest price is Goldman Sachs (NYSE: GS) at $193.41. That gives it a weight of 7.06%. New member Apple Inc. (Nasdaq: AAPL), with a stock price of $127.95, has a weight of 4.74%, despite having a market cap 8.5 times that of Goldman's.

At the other end of the scale, General Electric (NYSE: GE) has a weight of just 0.94%, thanks to its stock price of $25.41.

The Averages Committee says it does not want to switch to market-cap weighting for several reasons. First, it would ruin comparisons with historical Dow figures based on price-weighting.

The committee also argues that market-cap weighting makes other indexes more sensitive to investing fads such as the dot-com bubble of the late 1990s. However, back-testing shows that the DJIA would not behave that much differently if the weighting were based on market cap.

The short answer: The Dow is price-weighted and will stay that way.

Dow History: The committee changes its mind.

[epom key="ddec3ef33420ef7c9964a4695c349764" redirect="" sourceid="" imported="false"]The Averages Committee prides itself on the relative stability of the index. Still, more than 120 companies have been Dow components at one time or another. And some companies were in and out of the index several times.

Take General Electric, which proudly notes it is the only stock of the original 12 still in the index. But it was dropped - twice - in the Dow's early years.

GE was first kicked from the DJIA in 1898 in favor of the United States Rubber Company. The company was added back the next year, but got dropped again in 1901 to make room for U.S. Steel. General Electric re-entered the Dow for good in 1907.

Less common now, such swaps in and out of the Dow were not unusual prior to World War II. For example, General Motors (NYSE: GM) first joined the DJIA in 1915, but was dropped just one year later. GM didn't return until 1925. That stint lasted until 2009, when the automaker's bankruptcy forced it out again.

Don't Overlook the Dow Rejects: Whenever we see changes to the DJIA stocks, some investors assume the dumped companies should be avoided. But a look at the record indicates just the opposite. In fact, in the years that follow, most of the Dow rejects actually outperform the companies that replaced them. Here's why it happens - and how you can use this phenomenon to profit...

Follow me on Twitter @DavidGZeiler.


About the Author

David Zeiler, Associate Editor for Money Morning at Money Map Press, has been a journalist for more than 35 years, including 18 spent at The Baltimore Sun. He has worked as a writer, editor, and page designer at different times in his career. He's interviewed a number of well-known personalities - ranging from punk rock icon Joey Ramone to Apple Inc. co-founder Steve Wozniak.

Over the course of his journalistic career, Dave has covered many diverse subjects. Since arriving at Money Morning in 2011, he has focused primarily on technology. He's an expert on both Apple and cryptocurrencies. He started writing about Apple for The Sun in the mid-1990s, and had an Apple blog on The Sun's web site from 2007-2009. Dave's been writing about Bitcoin since 2011 - long before most people had even heard of it. He even mined it for a short time.

Dave has a BA in English and Mass Communications from Loyola University Maryland.

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