The Dow Jones industrial average index turned 130 in May. Business partners Charles Dow and Edward Jones founded Dow Jones & Company in 1882 and launched The Wall Street Journal in 1889. When they established the index in 1896, it was as a tool for business journalists to help create interest in markets and, ultimately, sell newspapers. The key idea behind the Dow Jones was to answer the simple question: “How did the market do today?” And for that, it was perfect.
But it was, and remains, an odd index because it is price-based. Most world indices, such as the local top 40, the MSCI and the US S&P 500 or Nasdaq, are market cap-weighted indices.
In other words, each stock’s weight in the index is relative to the size of the stock. So, if your company is twice the size (value) of mine, your company has twice as much weight or influence in the index. We do see some tweaking of that, such as free float, where shares held not for sale by a founder or holding company are excluded from the market cap.
But the Dow Jones has always been price-weighted. In other words, if your larger company has a share price of $10 and my smaller company has a $25 share price, mine would have 2½ times the influence in the index.
The reason for using price-weighted was to keep the calculations simple — they were being done by hand, not calculators
This is a wild concept that makes no real sense. The fact is that by using this odd methodology, the Dow Jones has managed to be around for 130 years. The reason for using the price-weighted methodology was to keep the calculations simple — they were being done by hand, not calculators.
The index is made up of 30 US-listed stocks and uses a divisor as a clever trick. The divisor used to be a simple 12 for the number of stocks in the index, but these days it’s 0.152. This means a $1 move in any single stock in the index moves the index by roughly 6.6 points. So, higher-priced stocks have more impact; as a result, the share price is part of the process of deciding which stocks are included.
The process for stock selection is another oddity. Other global indices have set rules (even though these rules are changed when the Nasdaq wants to fast-track SpaceX) to decide which stocks are included in an index. These rules are then applied on a defined schedule, usually quarterly. But the Dow Jones changes the stocks ad hoc as and when the S&P Dow Jones indices committee decides.
As to which stocks are included or kicked out, again there is no formal process — just the committee deciding which stocks best represent the US economy and attract investor interest.
Initially there were just 12 stocks, which increased to 20 in 1916 and to 30 in 1928. It works, even 130 years later.
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