It is difficult, at first glance, to determine the trends in the stock market and by implication in the underlying economy. Some stocks may be rising, others falling. Some may be very volatile, others very stable. In order to provide some indication of the market, Mr. Charles Dow and his statistician Mr. Edward Jones developed the concepts of a stock market ‘index’. The Down Jones Industrial Average (DJIA) was introduced in 1896, the second index after the Dow Jones Average in 1894.
A stock market index is designed to give a day by day indication of the rise and fall of either the equity market as a whole, or of specific industries in the market. In principle they measure some well-defined ‘average’ price for equities and are therefore influenced by all the shares comprising the index and not so much by any one share. The concept ‘well-defined’ is important here – unless investors know how the index is defined, how and why component equities are included, it is difficult to appreciate the importance of the index.
The Dow Jones Industrial Average consists of shares of 30 companies, up from the original 12. The shares are not from any specific industries. There is no automatic selection criterion as with many other indices (by size, by capitalization, weighted by industry, etc.). Instead a panel meets to choose a participant whenever the need arises. The only specified criteria are that the companies represented are considered to be sound, large, well established and well managed. Currently the companies represented include 3M, Cisco, Coca Cola, IBM, General Electric, and Procter & Gamble. The only time companies are added or removed is when the company has some corporate action such as merger, share split or takeover which makes the continuation unmanageable. Source: Dow Jones Averages)
As there are approximately 4100 company listings on the NYSE Euronext exchange, 30 cannot be considered a true average. However, because of the size of the companies included they represent approximately 27% of the free float of the Dow Jones U.S. TSM Index, which covers effectively the whole US market. The DJIA does therefore give a fairly good representation of the overall movement of the market and the underlying economy.
The DJIA differs from other main indices such as the S&P 500, the Wilshire 5000, or the Russell 3000 in that it is weighted by individual share price and not by market capitalization (total value of the company based on the number of shares multiplied by the share price).
A weighting by market capitalization is easily understood: – any movement in share price of the larger companies will have more effect on the index than a similar move in the share price of a smaller company. Intrinsically this ‘sounds’ correct as a larger company represents a larger percentage of the overall market.
A weighting by share price is less intuitive. It will mean that those companies with large share price (instead of large capitalization) will have more effect on the index than those companies with a low share price. As an example, share price movement of a ‘small company’ (valued at $1 million with 1000 shares of $1000 each) will have more effect on the index than a ‘large company’ (valued at $200 billion with 1.2 billion shares of $164 – e.g. IBM. Source Google finance).
Intuitively this appears wrong: the small company cannot be more indicative of the market as a whole. It is only useful if the underlying companies are all large bellwether companies, and it is a testament to the managers of the DJIA that it is so well accepted.
See also Wikipedia on the DJIA.