The Dow Jones / by kevin murray

The equity stock market has plenty of indexes that purport to represent the market, but the daddy of them all is the Dow Jones, named after Charles Dow and Edward Jones, who formed the nucleus of Dow Jones and Company, the future publishing company of the Wall Street Journal.  The Dow Jones Index was first published in the WSJ on May 26, 1896, and the average consisted of 12 stocks in which the simple addition of the closing price of the 12 stocks created the closing price of the Dow Jones.  By 1928, the Dow Jones consisted of 30 stocks and this remains true as of today, nearly 100 years later.  The oldest surviving member of the Dow Jones index is General Electric and the index itself makes few changes.  From the years 1999 to 2009, there were a total of eight additions and subtractions from the Dow Jones in which for most years there were no changes to the index at all.


The U.S. Stock market has approximately 5,000 stocks that trade on a given day, yet the Dow Jones represents just 30 stocks and it is considered by many to the be the "market" because these companies represent the "blue chips" of the U.S stock market.  Consequently, when most pundits report on the market on a given day, this reference is almost always referring to the Dow Jones and its 30 stocks.   Most of the names of the 30 stocks that make up the Dow Jones are recognizable to most people, (e.g. Coca-Cola, Microsoft, Disney, and IBM) because these stocks are huge corporations with massive sales, global presence, and market capitalization.  The Dow Jones is often seen as a proxy for the economy as a whole and that is why so many people pay attention to how the market is doing on a given day.


The one flaw within the Dow Jones average is that the "Dow" weighs companies solely by their share price as opposed to weighing them by their market capitalization, therefore you get the strange phenomena in which Visa at a current stock price of $222.81 and with a market capitalization of $141.18 billion dollars has a substantially greater influence on the Dow as compared to Cisco which has a current stock price of $21.82 and a market capitalization somewhat comparable to Visa at $112.66 billion.  Consequently, Visa has a current weighing of 8.75% on the Dow, making it the #1 influence on the index whereas Cisco current weighing is a mere .86% or a ratio of just over 10:1, conversely on a market capitalization ratio that ratio would be just 1.25:1.  Additionally, Visa has the lowest yearly revenue by far of any component on the Dow, and its market capitalization is also in the bottom five, yet Visa has the biggest influence on the Dow.  Quite simply, because the Dow weighs companies by their share price, instead of market capitalization, or by some other fair metric, certain companies within the Dow will have an outsized influence on the Dow price and others will have significantly less influence.  As it stands today, creating your own Dow Jones index is as simple as purchasing the exact same amount of shares of each Dow component.


The Dow Jones could change its formula for creating the index and perhaps should change it.  For instance, by market capitalization, the two biggest stocks are Apple and Google in which neither are part of the index and neither has any hope of being part of the index because of their very high stock prices of $532.36 and $1218.26, respectively.  Google, itself, if it was part of the index as currently formulated would be well over 33% of the weighing of the Dow.  Therefore, in absence of either Apple or Google splitting their shares and assuming that their market capitalization remains at or near the top, the Dow Jones will change its formulation sometime within the next decade in order to maintain its relevance.