The Dow Jones index is important to understand because it is a commonly-used measure of overall US market performance. However, it is not as scary (and perhaps not as important) as cable news might have you believe.
Where did the Dow Jones Index come from?
The Dow Jones Industrial Average gets its name from its original founders Charles Dow, a newspaper editor, and Edward Jones, a statistician, who teamed up to create an easy instrument that would allow folks to track the performance of the US economy.
Given that Dow and Jones lived at the end of the 1800’s (a time when America’s economy was very much based on industry) they opted to take into account the stock prices of America’s twelve largest industrial companies when creating the statistic off of which their index is based. The industry focus is also the basis for the name of this index.
What is the Dow Jones Index like today?
Over a century later, the Dow Jones Index is now composed of 30 companies from diverse industries, from foodservice to telecommunications. These companies are considered to be highly influential in their industries and in the global financial market. They include big names like Walmart, Procter & Gamble, Nike, and Pfizer.
However, these companies don’t have a permanent place on the Dow. If they lose value, they can be replaced by other, more valuable companies. For example, this happened to General Electric in 2018 after more than 100 years on the Dow Jones Index.
How does it work?
Given that the Dow Jones Index is always composed of industry leaders, it’s considered to be an indicator for how the overall market is functioning and fluctuating. That is, a particular change in the Dow Jones Index can indicate to investors changes across the market that could affect their stocks, too.
This is why investors and traders use the Dow as a benchmark to understand how the overall market and individual stocks are performing over time.
Is the Dow really all that?
One criticism of the Dow is that it is a price-weighted index. This means that massive companies that have a lot of financial and industry clout are effectively excluded from the Dow Jones Index, simply because the individual price of their stocks is too high. This includes huge companies like Google and Amazon.
The omission of these giants may affect the Dow’s accuracy in predicting market performance because such companies are so influential.
Additionally, because there are thousands of companies involved in the US stock market and the Dow is only made up of a handful of the largest ones, it’s fair to say that it may not be the best indicator of how the average American is doing.
Also, the global reach of these companies may help them outperform other companies that are confined to US soil, especially in times of hardship. As such, the price of stock in companies included in the Dow might reflect the wellbeing of many economies, not just the American economy.
Invest in the Dow Jones
While it’s not perfect, the Dow Jones is one of the most popular measures of market performance. Some folks like it so much that they even “invest” in it. It is possible to make investments that track the Dow Jones Index by investing in it directly or in particular Exchange-Traded Funds.
Because an ETF is a group of stocks from different companies, it is possible to buy an ETF that groups stocks from companies only included in the Dow. Generally, these ETFs fluctuate along with the Dow.
The Dow Jones Index is one of many measures of the US economy. Given its limitations, it’s not the end-all be-all of understanding market performance, but it is certainly a popular and important measure.
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