There is often a misconception that the likes of the Dow Jones, S&P 500 and the New York Stock Exchange (NYSE) are one of the same thing. Although all three constituents operate in virtually the same marketplace, they have some distinct differences.
In the case of the Dow Jones Industrial Average, or simply the Dow Jones, this refers to a stock market index that tracks 30 of the largest publicly owned companies operating in the U.S.
In our ‘What is the Dow Jones’ guide, we’ll start by giving you a brief background as to when and why the Dow Jones was created, alongside a deep breakdown of how it actually works.
Finally, we’ll conclude by giving you an overview of how you can make an investment in to the Dow Jones yourself.
Dow Jones: Background
The Dow Jones Industrial Average was first launched in 1896 by founder Charles Dow. The concept behind the creation of the Dow Jones was to facilitate a financial mechanism that would allow investors to speculate on the wider economy, rather than just a single company.
As such, the original Dow Jones tracked just 12 companies, in comparison to the 30 it tracks today. Back when the Dow Jones was first launched, and as the name suggests, the index was compiled purely by companies operating in the industrial arena.
This included companies from the tobacco, railroad, oil and sugar sectors. However today, very few of the 30 companies that make up the Dow Jones operate in an industrial-based business.
Nevertheless, this type of financial product is known as a ‘Stock Market Index’, insofar that it creates a weighted index of multiple companies. This subsequently allows investors to back the weighted performance of different companies operating in the different sectors.
One of the key differences between the Dow Jones and other major stock market indexes such as the S&P 500 is that the former hosts just 30 companies. On the contrary, the S&P 500 tracks 500 of the largest U.S. companies.
So now that you have a better understanding regarding the background of the Dow Jones, in the next section we will explore how the 30 companies are chosen.
How Does the Dow Jones Choose its 30 companies?
As with all stock market indexes, the Dow Jones has a systematic process when it comes to choosing the companies that make the index. Whilst the underlying process is complex in nature, we’ll break down the most pertinent points. Moreover, since the Dow Jones increased from 12 companies in 1928 to 30, the underlying component calculation has changed 51 times.
Nevertheless, the key thing to understand is that the Dow Jones uses something called a ‘Price Weighting’ calculation. In layman terms, this means that companies with higher share prices contribute a higher weighting to the Dow Jones average, in comparison to those that have smaller prices.
Interestingly, what this means is that although a particular company might have a smaller market capitalization than another company, if it has a higher individual share price, it can have a greater weight to the overall average.
Once such example of this is General Motors and the Travelers Companies. Regarding the former, at the time of writing General Motors has a total market capitalization of $86 billion, while Travelers stand at just over $34 billion.
However, because Travelers have a current share price that amounts to $131, and General Motors at just under $10, Travelers contribute more to the Dow Jones average!
In terms of the longest standing Dow Jones companies, this includes the likes of ExxonMobil, Procter & Gamble, Coca-Cola and IBM.
We should also note that while the vast majority of Dow Jones companies are taken from the NYSE, a small number of organizations are also listed on the NASDAQ. This includes the likes of Microsoft and Intel.
So now that you have an idea as to what sort of companies make up the Dow Jones, let’s take a look at how the index has performed historically.
How has the Dow Jones Performed Historically?
In a nutshell, over the course of time, the Dow Jones Industrial Average is expected to make gains on an indefinite basis. Although the index will experience downturns along the way, long-term recovery is more of a probability than a possibility.
One of the key reasons for this is that the Dow Jones makes sporadic adjustments to the companies that constitute the weighting, meaning that under-performing companies can be replaced. Ultimately, if the overall U.S. economy is performing well, then one would expect the Dow Jones average to follow suit.
However, one such criticism of the underlying mechanisms that constitute the Dow Jones weighting system is that it makes up such a small proportion of the wider U.S. economy. As there are now more than 5,000 individual stocks listed on the NYSE and NASDAQ collectively, the performance of just 30 companies may be somewhat misleading.
Not only this, and as mentioned earlier, smaller companies with a higher individual share price contribute more to the weighting system than much larger companies with a smaller individual share price.
Nevertheless, to give you an idea as to how the Dow Jones has performed over time, in 1919 the industrial average amounted to approximately 1,200 points. At the time of writing, this amounts to just over 25,000 points. As such, this illustrates a 100-year growth figure of more than 2,000%.
In more recent times, at the peak of the build up to the 2008 financial crisis, the Dow Jones average amounted to approximately 16,000 points. This bottomed-out in early 2009 at just over 8,000 points, and since then, the Dow Jones has been on a consistent up-wards swing.
Therefore, although the Dow Jones average lost close to 50% in response to the financial crisis, not only did it recover, but it has since continued to create new records.
We should make it clear that while the Dow Jones has experienced a consistently strong 100-year cycle, previous results can never be taken as a guaranteed indication of future trends.
So now that you know how the Dow Jones has performed historically, let’s take a look at how an investment actually works.
How do you Invest in the Dow Jones?
Although the Dow Jones is a stock market index, the underlying principles work in a very similar way to that of a traditional blue chip stock. The key reason for this is that investors are essentially speculating on the overall value of the Dow Jones average increasing over time. Thus, the aim is to sell an investment at a later date for a price higher than originally paid for.
However, the fundamental difference between an investment in the Dow Jones and that of a conventional stock is that you do not actually purchase the shares directly. This would be a highly complex and potentially costly process, not least because of the constant weighing alterations of each company that constitutes the index.
As such, the easiest way to speculate on the Dow Jones is to either use an index fund or an exchange traded fund (ETF).
Invest in the Dow Jones via an Index Fund
An index fund is essentially a third party organization that tracks the performance of the 30 companies that make up the Dow Jones. Each index fund will have their own underlying processes to mirror the performance of the Dow, so this is something that you need to check before parting with your money.
Moreover, known as the ‘Expense Ratio’, you need to check the fees that each fund charges, which should be expressed as a one-size-fits-all percentage.
Invest in the Dow Jones via an Exchange Traded Fund (ETF)
An alternative mechanism that will allow you to invest in the Dow Jones average is that of an exchange traded fund, or simply ETF. Essentially, an ETF is a financial instrument that allows you to invest in a range of markets without needing to own the underlying asset. For example, ETFs are hugely popular in = commodity markets such as Gold and Oil.
Read: What is an ETF?
In the case of the Dow Jones, an ETF will track the prices of each company that makes up the index, based on the same weighting constituents as the actual Dow itself.
One of the most established Dow Jones ETF is that of the SPDR Dow Jones Industrial Average ETF. First launched in 1998, the SPDR actually purchases the stocks of each Dow Jones company, subsequently weighing each investment based on the Dow Jones system.
Not only does the SPDR Dow Jones Industrial Average ETF allow you to invest in the growth of the Dow, but you can speculate in reverse. In other words, if you think that the price of the Dow Jones will decrease in the short-term, then you can bet against the market.
Ultimately, whether you opt for a traditional Dow Jones index fund, or an ETF, just make sure that you have a full understanding of who the brokerage firm are, what fees they charge, and perhaps more importantly, how they actually track the Dow itself.