The Dow Jones Industrial Average (DIJA) is named after its creator Charles Dow. His firm, Dow Jones & Co. gave rise to The Wall Street Journal, which any savvy investor should read.
You may watch the news every day and hear the Dow has risen or fallen so many points. It’s one of the most popular stock indexes in the world. However, even loyal followers may not be able to tell you what the Dow measures or what it means.
That’s where we come in to give you a little background on the topic. How is the Dow calculated? What does it measure?
Read on to find out.
Understand Stock Indexes
To understand the Dow, you need to understand what a stock index is and what it does. A stock index is simply a bundle or basket of stocks.
When you invest in an index, you invest in the whole basket of stocks rather than individual companies. The Dow is such an index.
The Dow started out as a basket of 12 different stocks Charles Dow considered to be commodities. Over the years, the Dow has dropped and collected new and different types of stocks.
The Dow today consists of 30 different stocks. There are no requirements to be part of the Dow. However, each company must be substantial and represent a substantial portion of US economic activity.
How Is the Dow Calculated?
What does the Dow actually measure, and how are the numbers calculated? The process of calculating these numbers is actually quite simple and straight forward.
As the name of the Dow Jones Industrial Average implies, the numbers are averages. The price of each stock in the Dow is added up and divided by some divisor. The Dow divisor changes from day to day.
In the beginning, the Dow divisor was equal to the number of stocks within the index. Over time, stock splits and other corporate actions drive the divisor lower.
Today, the resulting “average” isn’t a true arithmetic average.
Why Is the Index Higher Than the Sum of Prices?
You may notice the sum of the prices of individual stocks in the Dow is lower than the index itself. This is because the Dow divisor is less than 1.
The index numbers need to remain consistent with the price and value of individual companies over time. When a stock splits, the company’s price may change while the value remains constant.
With an unchanged divisor, the index would represent different values before and after the event. This would be inaccurate.
Should You Invest in the Dow?
Index investing is tricky business and should never be taken lightly. You should consider risk and volatility. While the businesses in the DJIA are well-established and unlikely to go bankrupt, the prices can fluctuate dramatically.
What is the Dow? How is the Dow calculated? If you’re thinking about investing in the Dow or associated companies, you should do more research and gain experience.
Are you looking for a good place to start on this journey? Visit our money section to learn more about investing, saving, and managing your finances.