What is the Dow Jones Index?

Dow Jones Industrial Average

People often confuse Dow Jones with the Dow Jones index. Often referred to as the Dow, the Dow Jones Industrial Average is one of the most-seen stock indexes in the world, comprising companies such as Exxon, Microsoft, Apple, and Coca Cola. It was first started in 1896.

Dow Jones, the company, owns the Dow Jones index along with multiple indexes that represent various factors of the economy, including the Dow Jones Transportation Average, which is the oldest index, tracking twenty transportation companies including delivery services and airlines. The Dow Jones Utility Average is another major index that tracks fifteen US utility stocks. 

The Dow Jones index measures the everyday price movements of thirty large American companies on the New York Stock Exchange and the Nasdaq. The Dow Jones industrial average or DJIA is made of blue-chip stocks, almost two-thirds of which are depicted by companies that produce consumer and industrial goods. The rest are selected from other major sectors such as entertainment, financial services, and information technology. 

The Dow Jones index is known as the pulse of the stock market because it is the most quoted and followed by financial professionals, investors, and the media. 

Calculating the DJIA

The DJIA was calculated hourly, by hand, for several years. Back in 1896, Dow would simply assess the prices of the twelve stocks and divide them by 12. In 1923, Arthur Pop Harris was given the task of determining these numbers. The original 12 firms were:

• American Sugar
• American Cotton Oil
• American Tobacco
• Distilling & Cattle Feeding
• Chicago Gas
• General Electric 
• National Lead
• Laclede Gas
• Tennessee Coal & Iron 
• North American 
• US Rubber 
• US Leather Pfd. 

After he retired in 1963, computers were utilised to calculate the figures. There was a delay of approximately seven minutes between the closing of the NYSE and the final figure coming out over the wires. However, with time, electronic technology has enabled a consistent minute-by-minute calculation of the mean or average while the market is trading. 

The Dow Jones index is a price-weighted index, which implies that stocks with higher share prices are given major weight in the index. Rather than dividing by the number of stocks in the average, as is performed in an arithmetic average, the sum of the component prices of the stock is calculated using a special divisor. 

The purpose of this divisor, which is continually adjusted, is to wrinkle out the effects of dividends paid, stock splits, or corporate spinoffs. This allows for a constant index, keeping the Dow from becoming distorted by one-time events. 

The result is that the DJIA is only affected by changes in the prices of stocks, and stocks with higher share prices have a bigger impact on the Dow’s movements. 

What the DJIA Measures

The Dow Jones index is only a reflection of the weighted average of stock prices and can be taken as a price in itself. If the quote decreases by 80 points at closing time, you can attain the stocks for $80.00 less and they are worth less than the previous day. 

Overall, an increase in the Dow signifies an escalation in the prices of a share of constituent companies that show a positive outlook and vice versa. The DJIA can eventually be employed as a benchmark for the economy. 

The biggest single-day percentage drop was on 19 October 1987, when the index decreased by 22%. After that, the largest fall took place on 28 October 1929, when it fell by around 12%. Not surprisingly, these falls coincided with times of economic instability in the US.

However, you must remember than an increase in the Dow Jones index may be due to a significant rise in the prices of a share of a single company, which can overlook the fall in the prices of a share of other stocks. 

So, even if you have shares of a constituent company, an increase in the Dow might not necessarily indicate that the prices of the company you are investing in are rising. The Dow shows the average trend of all thirty stocks together. The direction is guided by which side is stronger and how the share prices are falling or rising. 

Structure of DJIA

The DJIA contains 20 large-cap blue-chip companies, which are household names. Ironically, the DJIA is not a true proxy for the industrial sector, as only several of the companies that constitute the Dow Jones index are classified as industrial. Other companies are assigned to the remaining sectors that are located in the Global Industry Classification System. The utilities sector is the only sector that is not represented by a company in the Dow Jones Industrial Average. 

Along with the sector diversity of the DJIA, further diversification is offered by the multinational operations of its components. This means that investors can have indirect exposure to the international markets and utilise the global diversification of the firms in the index to hedge against the unfavourable impact of a weak US economy. 

Moreover, the firms that make up the Dow generate a particular amount of revenue every year. This helps to reduce the business risks of firms that make up the index. 

Criticism of DJIA

Although the DJIA has several excellent attributes, its biggest criticisms come from the fact that it is a price-weighted index. This implies that each firm is assigned a weighting based on its stock price. 

In comparison, the majority of the companies that make up the index are weighted as per their market capitalisation. The S&P 500, an index that is distinct from the DJIA in several ways, is a good example of this. 

As you can assume, there would be a notable difference in the weighting of the firms in the  Dow Jones index if the index committee employed market capitalisation instead of stock prices to structure the index proxy. 

That said, there is nothing that makes the market-cap-weighted index, revenue-weighted index, or an equally-weighted index superior to the price-weighted index. This is because the idiosyncratic nature of every index construction method has several weaknesses and strengths, which makes it difficult to determine the best method. 

An Important Difference Between Risk and Volatility

When analysing the performance of the Dow Jones index, it is vital to remember that a few consider it to be a volatile index. Thus, multiple investment professionals will not usually recommend investing in products that follow the DJIA. 

That said, there is a notable distinction between the business risk of the firms that make up the Dow Jones index and its volatility. This is because firms that constitute the DJIA represents thirty of the best-established firms in the world. As a result, their business risk is comparatively lower, as it is very unlikely that these companies will go bankrupt. 

Nevertheless, the price of the stock of these firms can fluctuate notably over short periods. Therefore investment products that imitate the performance of the Dow can experience massive short-term losses and gains. 

Investment Strategies for New Investors

Investors must understand that there is potential for massive losses if they invest in products associated with the Dow Jones index. Thus, the strategies given below are not for inexperienced investors who want to benefit from an ‘invest and forget it’ strategy. 

That said, several strategies can be utilised that are better than the strategies touted by the majority of financial advisors. However, these strategies require a change in philosophy to take them from the uncomplicated buy-and-hold mentality to strategies that have a relatively shorter time horizon. Such strategies are:

• Protective Put 

This strategy comprises a long position in a Dow ETF or exchange-traded-fund and the buying of ‘put’ options on the same underlying ETF. This strategy is beneficial if the DJIA escalates and will safeguard your investment if the DJIA does down. 

• Covered Call 

Investors can finally produce a modest premium on top of a long Dow ETF position by applying a covered call strategy, which entails selling call options and buying the DJIA ETF on the same underlying ETF.

This strategy will generate gains if the Dow remains relatively flat and does not surpass the strike price of the call options sold. That said, a covered call strategy does not offer any downside protection, so investors should be confident that the Dow will be lying flat before applying this strategy. 

• Short Selling

In contrast, investors can apply a protective, short selling strategy of buying call options and selling short the Dow ETF on the same underlying ETF. This strategy will be lucrative if the DJIA falls and will protect your investment if the DJIA rises.

• Top Ten

This strategy involves investing the same amounts in the ten stocks of the DJIA with the topmost dividend yield at the beginning of a year and retaining them until the year-end, at which time the investor sells stocks of that year and deploys the gains into the new stocks for the coming year. 

The Bottom Line

The Dow Jones index continues to serve its original purpose as an economic and market indicator, as set forth by Charles Dow. As long as it comprises the stocks of companies that reflect the most industrial areas of the US economy during any particular period, this thirty-stock index will likely be the gold standard of financial indicators. If you want to enter the DJIA, the above-mentioned strategies make it easier for you to do so.