Listen to Episode 14 on my Financial Breakaway Podcast
In my career as a Financial Advisor in the Milwaukee, WI area I see a lot of misunderstanding about or just plain wrong understanding of the Dow 30 Index. In this post I want to discuss how it actually works and throw in a little history about it. Then I really want to get into how the Dow 30 Index has become the headline of most news outlets as the barometer of the market, or how it’s done that particular day, etc. I'm going to argue that there's a huge disconnect there to the everyday investor and that you should really not even give two licks about the Dow 30 Index when it comes to your personal investing.
Let's start with some history
The Dow or the Dow 30 are the abbreviated names for the Dow Jones industrial average. It was first calculated back in 1896 by a man named Charles Dow, who was the cofounder of the Dow Jones & Company…which was and is today (in a form) a media and publishing company. Charles was also the editor of the Wall Street Journal which his company published. (hint hint that fact alone should be some foreshadowing to what I'm going to talk about)
Charles Dow Named it the “industrial average” because he wanted to track the Titans of American industry of that time. He originally started out with 12 stocks such as Chicago gas, General Electric, Tennessee coal, US rubber, American Tobacco. Side note, General Electric had the longest run in the Dow Jones continuously for over 120 years until it was removed in 2019. Also an interesting fact is that when the index was first published it stood at a level of around 62, now in mid October of 2021 at the time of writing this post the Dow index stands at over 35,000. Pretty crazy. The Dow index was increased over the years from the 12 stocks to to 20 stocks in 1916 and then to 30 stocks in 1928 at the height of the roaring 20s. And it has been 30 stocks ever since
How do companies get into the Dow 30 Index in modern day?
There really is no rules for which companies get included in the Dow... there are some broad guidelines as they require large respected companies that have high stock prices, but that is about it. There's a committee made up of what is now the S&P Dow Jones Company representatives and Wall Street Journal editors that decides which companies are included in the index. I can guarantee you that most people do not know that it's really an index that's created by journalists. I'm not here to say that that's good or bad I'm just here to point that fact out and they say that it's interesting.
Currently, the Dow 30 Index has done away from just industrial companies and the committee tries to maintain good sector representation (such as health care information technology, financials, consumer discretionary… however industrials still make up over 16% of the index today in mid October of 2021.
How the Dow 30 Index is Calculated: Price Weighted Index
Originally when Charles Dow started the index he would simply take those twelve companies at the end of each day, he would add up all of their closing prices, and then divide by 12 to get an average that was then reported the next morning in the Wall Street Journal.
Essentially the Dow is calculated very much the same with the 30 companies (now in today’s world it’s not just divided by 30, it has what they call a divisor which accounts for any stock splits or things like that). This is called a price weighted index meaning companies that have a higher stock price impact the index more than companies that have a lower stock price.
if you go to https://www.slickcharts.com/dowjones you will see a good visual of these companies ranked highest to lowest on their stock price. Or another way to think of it they are ranked according to their weight in the index because the higher the stock price the more weight it carries in the index. The obvious next question is what is the highest priced stock in the Dow or what has the most weight in the Dow? And it might be surprising to you because it's United Healthcare and it currently has a weighting of just under 8% with a stock price of $428.07 as of 10/16/21 (the top ten companies in the Dow 30 weighing make up over 46% weight of the Dow 30 Index). The smallest company in the Dow right now is Walgreens boots alliance which has a weighting of .95% with a stock price of $52.27 dollars
Why the Dow 30 Index must go
In this type of price weighted index, if the companies with the higher stock price have a bad day on the market it's going to affect the index a lot more than those companies with a lower stock price…EVEN if that company is smaller in market cap size? It really make’s no sense. The good news is, that anyone remotely in the investing industry commonly considers it an inadequate representation of the overall U.S. market. However, to the everyday person they don't know this because it's broadcasted on the news every second of the day. Now, I'm not discounting that we need barometers like this to figure out how the market is doing...I'm just trying to connect the dots for people to know what they're investing in and how it works such you can make the best decisions for your own particular situation.
What I mean is that I think “it should go” from the new stations and being talked about as one of the main metrics of the US stock market. I can't tell you how many times a day I hear “market was up 500 points" or "gezz market dropped 600 points today." They don’t even have to say “Dow” they just say “market” and it's assumed that people are talking about the Dow 30 Index…and that’s my gripe.
As I mentioned, if you're even a little bit in the industry we know that the Dow 30 isn't enough stocks to be representative of the US market the S&P 500 index does a better job at that so why don't we just use that… now I pointed out what I wouldn't call flaws but just how that SP500 index works the mechanics of it that people need to know things that affect the price of that index. But at least it has quantitative rules to the addition and subtraction of companies into or out of the index, and it accounts for the actually size of the company not just an arbitrary number like a companies stock price.
Overall my goal was for you to understand at least why the Dow gets broadcasted everywhere even today because of it’s history being started by newspaper publishing company owner to be reported in his newspaper…and that has stuck ever since.
Okay that’s it for me today, hopefully I gave you a lot to think about. Thanks for reading and until next time…be well.