How Well Do You Know the Dow Jones Industrial Average?

Over the 119-year
Dow Jones Industrial Average

history, the index has become synonymous with the markets. Most
investors check on the
DJIA

at the end of every trading day, if not more frequently.

But how much do investors really know about the index they rely
on?

Other than that it contains 30
blue-chip stocks

, few investors give much thought to how the DJIA came about or why
it’s structured the way it is. And yet the Dow Jones Industrial
Average history is key to understanding what the index is really
telling us every day.

Here are five important
Dow facts

that show how this powerful index came to be the world’s most
widely tracked measure of stocks…

Dow Jones Industrial Average: 5 Must-Know Facts

Dow History: The DJIA was the first index.

Before Charles Dow created the DJIA in 1896, investors had no way
of identifying trends in the overall market. Was it a bull market
or a bear market? No one knew. There was no way to tell.

Charles Dow wanted to summarize the stock market with one
easy-to-grasp number. He did this by selecting the 12 stocks he
felt best represented the American economy at the time.

Today it’s hard to imagine what a breakthrough this was. But
imagine trying to follow the markets without
any

market indexes!

By giving investors a simple, reliable, and consistent tool for
measuring market movements, Dow actually changed investing. Knowing
the overall trends helped investors make better decisions. Thanks,
Charles Dow!

Dow History: There’s a good reason the DJIA has only 30
stocks.

As noted above, the Dow Jones Industrial Average debuted with 12
stocks [
get that list – and where those companies are now –
here

]. It expanded to 20 stocks in 1916 and to 30 stocks in 1928,
presumably reflecting the rapid growth in the U.S. economy. But the
U.S. economy has grown vastly larger since 1928. Why don’t we have
50 DJIA stocks, or 75, or 100?

In fact, the Averages Committee, which makes decisions on the
components of the Dow, several years ago considered increasing the
roster to 50 stocks. It chose to keep the number at 30.

“The number of stocks is not nearly as important as the ones we
pick,” the SP Dow Jones Indices company explains on its
website. “The Dow could have 50 or 100 components, but unless the
mix was right it would not work as a market barometer.”

“Getting the mix right” is also why Dow Jones Industrial Average
stocks are chosen by humans, and not defined by a class of data
such as market capitalization.

Which brings us to the next quirk of the DJIA…

Dow History: The Dow Jones is not really an
average.

Although the word “average” is in the name, the Dow is really an
index. What Charles Dow did was an average, but that changed in
1928 when the DJIA expanded to 30 stocks from 20.

To maintain price continuity, the Dow divisor was born. It
prevents any change, whether it’s a change in the components or a
stock split, from affecting the index. Each such change requires a
new Dow divisor.

The first divisor in 1928 was 16.67. The current divisor, to
accommodate the March 19 addition of Apple, is 0.14859.

Dow History: The Dow Jones Industrial Average is
price-weighted.

While not often discussed, the influence of each Dow Jones stock
on the index depends on its price. Most other indexes weight by
market cap.

The most expensive DJIA stocks move the index far more than the
least expensive. The current stock with the highest price is
Goldman Sachs (NYSE:
GS

) at $193.41. That gives it a weight of 7.06%. New member Apple
Inc. (Nasdaq:
AAPL

), with a stock price of $127.95, has a weight of 4.74%, despite
having a market cap 8.5 times that of Goldman’s.

At the other end of the scale, General Electric (NYSE:
GE

) has a weight of just 0.94%, thanks to its stock price of
$25.41.

The Averages Committee says it does not want to switch to
market-cap weighting for several reasons. First, it would ruin
comparisons with historical Dow figures based on
price-weighting.

The committee also argues that market-cap weighting makes other
indexes more sensitive to investing fads such as the dot-com bubble
of the late 1990s. However, back-testing shows that the DJIA would
not behave that much differently if the weighting were based on
market cap.

The short answer: The Dow is price-weighted and will stay that
way.

Dow History: The committee changes its mind.

The Averages Committee prides itself on the relative stability
of the index. Still, more than 120 companies have been Dow
components at one time or another. And some companies were in and
out of the index several times.

Take General Electric, which proudly notes it is the only stock
of the original 12 still in the index. But it was dropped – twice –
in the Dow’s early years.

GE was first kicked from the DJIA in 1898 in favor of the United
States Rubber Company. The company was added back the next year,
but got dropped again in 1901 to make room for U.S. Steel. General
Electric re-entered the Dow for good in 1907.

Less common now, such swaps in and out of the Dow were not
unusual prior to World War II. For example, General Motors (NYSE:
GM

) first joined the DJIA in 1915, but was dropped just one year
later. GM didn’t return until 1925. That stint lasted until 2009,
when the automaker’s bankruptcy forced it out again.

Don’t Overlook the Dow Rejects: Whenever we see changes
to the DJIA stocks, some investors assume the dumped companies
should be avoided. But a look at the record indicates just the
opposite. In fact, in the years that follow, most of the Dow
rejects actually outperform the companies that replaced
them.

Here’s why it happens – and how you can use this
phenomenon to profit…

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@DavidGZeiler
.