What does the Dow Jones Industrial Average measure?

The Dow Jones Industrial Average (DJIA) is the second-oldest and best-known stock market index. Owned by Dow Jones & Company, it measures the daily price movements of 30 large American companies on the Nasdaq and the New York Stock Exchange. It is widely viewed as a proxy for general market conditions and even the U.S. economy itself.

Started in 1896, the DJIA is comprised of blue-chip stocks, approximately two-thirds of which are represented by companies producing industrial and consumer goods. The rest are chosen from all the major sectors of the economy including information technology, entertainment and financial services.

The Dow Jones Industrial Average (DJIA), popularly referred to as “The Dow,” is regarded as the “pulse of the stock market,” as it is one of the most quoted and followed stock market indexes by investors, financial professionals and the media. The Dow was unveiled on May 26, 1896 by Charles H. Dow and Edward Jones as a composition of 12 industrial-company stocks. Dow, a financial journalist, believed that investors should have an impersonal, numbers-based benchmark to see how the stock market was trending. The published average of the first index was a roaring 40.94.

Today, the DJIA's components are chosen from all the major sectors of the economy, with the exception of the transportation and utilities industries. Stocks from these sectors are covered by the Dow Jones Transportation Average (DJTA) (which was Dow and Jones' first index, the oldest in the U.S.) and Dow Jones Utility Average (DJUA). The current roster includes the likes of Apple, Goldman Sachs, Microsoft, Coca-Cola, Exxon Mobil and General Electric (the only corporation that has been included since 1896).

The component stocks of the DJIA are not permanent; new additions and deletions are made from time to time based on certain non-quantitative criteria. Only companies with a substantial growth record and wide investor interest are considered for inclusion. 

The DJIA was calculated by hand hourly for a number of years. Back in 1896, Charles Dow simply added up the prices of the 12 stocks and divided them by 12. In 1923, Arthur “Pop” Harris was assigned the task of calculating these numbers. After his retirement in 1963, computers were used to calculate the figures. Originally, there was a delay of about seven minutes between the close of the NYSE until the final number came out over the wires. Eventually, electronic technology enabled a constant minute-by-minute calculation of the average while the market is trading.

The DJIA is a price-weighted index, which means stocks with higher share prices are given a greater weight in the index. Instead of dividing by the number of stocks in the average, as is done in an arithmetic average, the sum of the component stock prices is divided by a special divisor. The purpose of this Dow divisor, which is continually adjusted, is to smooth out the effects of stock splits, dividends paid or corporate spinoffs; this allows for a consistent index, keeping the Dow from getting distorted by one-time events. The result is the DJIA is affected only by changes in the stock prices, and stocks with a higher share price have a larger impact on the Dow's movements. 

The DJIA is simply a reflection of the weighted average of the stock prices and can be considered a price in itself. If the quote moves down by 80 points at the time of closing, it means you can get the stocks for $80.00 less (taking into account the divisor) and they are less valuable than the previous day. Overall, a rise in the Dow signifies a rise in the share prices of constituent companies that reflect a positive outlook and vice versa.

Over time, the DJIA can be used as a benchmark for the economy. The largest single day percentage drop in the DJIA was on Oct. 19, 1987 when the index dropped over 22%. The second largest decline occurred on Oct. 28, 1929 when it dropped around 12%. Not surprisingly, these drops coincided with times of financial instability in the United States.

But remember, a rise in the index may be because of a substantial rise in share prices of a single company that is able to outweigh the fall in share prices of a few of the other stocks. So, even if you are holding shares of a constituent company, a rise in the Dow may not necessarily be indicative of the share price of the company you're invested in moving up. The Dow indicates the average trend of all 30 stocks together; the direction depends on which side is stronger—rise in share prices or fall in share prices.