The index of 30 Dow Jones Industrial stocks, often referred to simply as the Dow, has been around in some form or other for over 100 years. But as it is no longer entirely made up of “industrial” issues and not actually an “average”, is it still relevant? Exactly what purpose does it serve? Does it really represent a snapshot of the market? Is it a useful benchmark against which to measure performance? Is it fairly weighted? Do historical comparisons mean anything? How can the individual investor use it? How does it compare with other indexes?

Dow, Meets Jones

The first Industrial Average, compiled by journalist Charles H. Dow, along with his associate Edward Jones debuted in 1896, and was made up of 12 stocks.  The figure was arrived at by simply adding the component stock prices together and dividing by the number of issues. Not terribly sophisticated, but it was a start. Now, at least, comparisons could be made between past and present, between individual stocks versus the group, and against various economic statistics, such as, say, between railcar loadings or raw materials costs and prices.  But mostly it was designed to help “the man on the street” monitor the market’s general trend. Namely, progressively higher numbers were taken to indicate a bull market, while overall declines meant the bear was in session.

Dow Theory and the Birth of Technical Analysis

Although never actually designated as such by Charles Dow, but instead constructed posthumously by associates and followers based on his editorials, what became known as the Dow Theory is widely recognized as one of the earliest methods to use the market’s movements to gauge the health of the business environment. In a nutshell, as Dow believed that market prices reflect all available information, rising equity quotations presaged improving economic conditions. Likewise, the time to buy stocks was when the Industrial and Rail (now known as Transportation) averages were both trending higher, and vice versa.

Changing with the Times

In its earliest incarnation, the Dow included all of the nation’s existing industrial corporations, outside of the railroad companies. In time, America’s manufacturing base expanded, and the index became more of a select representation of the entire market.  The famous Dow 30 that we’re all familiar with today didn’t come into being until 1928. That was also when it technically stopped being an average. Instead, it began being calculated using a divisor to adjust for stock splits, spinoffs, and substitutions, and to maintain historical continuity.

The 30 components of the Dow Jones Industrial Average are reviewed on an as-needed basis by the editors of the Wall Street Journal and are largely selected for their “blue chip” qualities. These consist of established, well-regarded, and widely followed companies with a history of growth and sound financial footing. These are usually the largest representative samples of their particular market sectors, the exception being transportation and utility stocks, which have their own indexes.

Since 1928, there have been dozens of changes made to the list, reflecting the evolving makeup of the U.S. economic landscape.  Of the original 30, only two are included today; General Electric (GE - Free Analyst Report), which dates back to the original 12, and Exxon Mobil (XOM - Free Analyst Report), a descendent of Standard Oil.

Standard, Meet Poors

In 1923, Standard Statistics came out with a composite index of 233 stocks. Because of human computational limits, this was only published weekly. Realizing the need for more timely data, a slimmer subset of 90 stocks was introduced in 1928, made up of 50 industrials, 20 utilities, and 20 railroad issues. This was published daily, and became known as the S&P 90 Stock Composite Index.

About three decades later (and after merging with Poor’s publishing in 1941), largely thanks to early electronic computers gaining wider usage, the S&P 500 Composite Stock Price Index was introduced. As opposed to a common misconception, the components are not simply the 500 largest U.S. companies, but are made up of the leading publically traded entities within the important industry groups indicative of the U.S. economic makeup. These are selected by committee, taking into consideration market cap, financial viability, market liquidity, and industry and sector representation, among other factors. The index is reviewed on a regular basis and, because of its larger, more inclusive size, it tends to have far more changes than the Dow in any given year.

Weighing the Differences

Besides the number of issues represented by each, the major difference between the Dow and S&P is in how they are calculated. The former is price weighted, so higher-priced issues carry more sway. As such, their importance to the index will not be in the same proportion to that of the market at large.  So a move in a stock like International Business Machines (IBM), currently the highest priced Dow component, will have nearly 12 times the impact of the same move in Alcoa (AA), which is currently the lowest priced component. Indeed, the 10 highest priced issues account for more than 50% of the index’s movement.

The S&P, meanwhile, goes by market capitalization, which takes into consideration the relative size of a company. That is, a stock’s price is multiplied by the number of shares outstanding. This total is then divided by an index divisor. As such, the companies that have the highest market caps carry more weight. Even with all this diversification, however, the top 50 companies tend to make up more than half the Index’s total value.

Your Mileage May Vary

In addition to the Dow not completely representing the “market”, being only 30 stocks and all blue chips, and the aforementioned weighting issues that tend to distort the true picture, its use as a measure of historical rates of return also comes into question. A quick glance at the Dow’s long-term price chart shows a generally rising line. However, as with indices in general, over time, it tends to be skewed toward successful companies. Indeed, the Dow from 80 years ago is not the Dow of today. Once mighty names like, Nash Motors, Radio Corporation, Wright Aeronautical and American Smelting are no longer around, having either merged or gone out of business. As some market pundits have noted, all stocks go to zero in the long run. If you take out all the failures or struggling companies, you’re only left with growth stocks. That may be all fine and good for an index, but what if you had actually owned those individual stocks? Your results would have been a lot different. The discrepancy may not be significant during a growth cycle, but tends to be amplified during economic downturns. Looking at some current examples, among the more notable recent lineup changes, American International Group (AIG) was escorted out of the Dow club in September, 2008, followed by Citigroup (C) and General Motors in June of 2009. If you held onto GM as it went to zero due to bankruptcy, you had a big hole in your portfolio and had to replace it with actual money, not just a “component”. So, that seemingly steady long-term climb in the averages doesn’t quite tell the story.

Another problem when looking at the long-term trends is that it makes no account for inflation adjustments. From an original level of $40.94 in May 26, 1896, the Dow index has certainly come a long way. But how much would those 40 bucks be worth in today’s dollars? Well, taking a nice even number of 3% annual inflation, those original issues should theoretically have been worth about $1,190 this past May. That is, if they were still around. Another issue distorting performance comparisons is the fact that the frequently quoted S&P and Dow numbers don’t include dividends, which account for a large part of long-term investor returns.

A Handy Barometer

To be sure, the Dow Industrials has its flaws. However, it’s one of the most widely recognized proxies for stock conditions, and it does aim to offer a fairly reliable representation of market movements. For that matter, most any other index made up of general stocks could serve just as good a purpose, and adding more stocks doesn’t markedly improve its utility.  For evidence of this, one need only overlay the charts from various-sized indexes and it will become immediately apparent that stocks, in general, tend to move in sync. Very rarely will the Dow have a big up day that isn’t mirrored in nearly every other index.

All that Charles Dow was looking for was to create a handy tool that can be interpreted quickly, providing a directional sense for conditions rather than a detailed analysis. It is kind of like an investment barometer. Every now and then you look at it to see which way the market weather is going; A simple indicator of whether conditions are getting better or worse. Moreover, being familiar to so many, it’s a universal language that most will understand. As such, and with all its flaws, it’s among the most recognized, closely watched, and quoted indicators of market activity, particularly for the layman and the media.