Understanding the Dow Jones Index: A Beginner's Guide

Established in 1896 by Charles Dow and Edward Jones, the Dow Jones index has become synonymous with measuring the performance of the US stock market.

Comprising of 30 major publicly traded companies, the Dow Jones Index provides investors, analysts, and economists with crucial insights into the overall health and direction of the American economy.

In this article, we look into everything there is to know about the Dow Jones Index.

What is the Dow Jones Index?

The Dow Jones Index, also known as the Dow Jones Industrial Average (DJINDICES:^DJI) is a stock index/portfolio consisting of the 30 largest and most influential companies in the United States. It is considered an indicator of the overall health and performance of the US stock market and is directly proportional to the US's health as an economy, too.

As the economy changes, the Dow Jones Index's components can change too. If a company becomes less important or faces financial difficulties, it may be removed from the index and replaced by a different company that better represents the current economic trends. For example, in 1999, some companies like Chevron and Sears Roebuck were removed from the DJIA, while others like Home Depot and Microsoft were added. These changes reflect how the economy was changing at that time.

The Dow Jones Industrial Average includes stocks from various sectors and industries except transportation and utilities. Both of these industries are monitored by other specialized indexes like the Dow Jones Transportation Average (DJTA) and Dow Jones Utilities Average (DJUA).

Dow Jones Transportation Average

The Dow Jones Transportation Average, also known as the Dow Jones Transports or DJTA, tracks the performance of 20 transportation-related companies.

In its early days, the index primarily comprised nine railroad companies, with only two companies representing industries other than railroads. Later other transportation industries like airlines, railroads, trucking companies, shipping firms, and logistics providers were included in the index.

Dow Jones Utilities Average

The Dow Jones Utility Average, also known as the Dow Jones Utilities or DJUA, was created in 1929 and focused on the performance of 15 utility companies. These companies operate in sectors such as electricity, natural gas, water, and other essential services.

The DJUA provides insights into the stability and profitability of utility companies, which are often considered defensive stocks due to their consistent cash flows and relatively stable demand. Fluctuations in the DJUA can be influenced by factors such as energy prices, regulatory changes, weather patterns, and shifts in consumer behavior. Some examples of companies that are included in the index are Duke Energy, FirstEnergy, Exelon and more.

History of the Dow Jones Index

Originally, the Dow Jones Industrial Average consisted of only 12 companies, predominantly industrial giants like 3M. However, as the index's purpose evolved from solely assessing the performance of the heavy industrial sector to providing a broader representation of the entire US stock market, its constituent count gradually expanded.

Since 1928, the Dow Jones Index has consistently tracked a total of 30 carefully selected companies from various industries like technology, finance, consumer goods and more. This adjustment ensures a more comprehensive and accurate reflection of the market's health and serves as a vital benchmark for investors and analysts.

The index has also gone through significant market fluctuations like –

• The stock market crash of 1929 and the subsequent Great Depression caused the DJIA to retrace its steps, reaching 89% below its peak.
• The Black Monday crash of 1987 sent the DJIA tumbling by nearly 508 points, representing a staggering 22.6% decline.
• Following the September 11, 2001, terrorist attacks in New York and Washington, the markets were temporarily closed. When they reopened on September 17, the DJIA experienced a significant drop of approximately 17%.
• One of the most substantial declines in the DJIA's history occurred on March 9, 2020, amidst the outbreak of the COVID-19 pandemic in the United States. The index plummeted by nearly 3,000 points (nearly 13%), marking the onset of a series of drops throughout March.

** Past performance is not a reliable indicator of future performance

How is the Dow Jones Index calculated?

The DJIA is a price-weighted index that measures the daily price fluctuations of the 30 prominent American companies listed on the Nasdaq and NYSE. A price-weighted index means that stocks with higher share prices carry more weight in the index. Instead of dividing by the number of stocks in the average, as done in an arithmetic average, the sum of the component stock prices is divided by a special Dow divisor.

The Dow divisor is adjusted regularly to account for stock splits, dividends, or corporate spinoffs, ensuring the index remains consistent and unaffected by one-time events. As a result, changes in stock prices have a direct impact on the DJIA, with stocks having higher share prices exerting a more significant influence on the index's movements.

The DJIA is calculated differently from other indexes and does not directly show the size of the companies in it. Instead, it is based on the prices of one share of stock from each company in the index. This means that if one company's stock price goes up or down by one point, it will affect the DJIA by the same amount.

How can one invest in the Dow Jones Index?

1. Individual stocks

Buying shares of each company included in the Dow Jones Index allows investors to directly own a portion of each company's stock. Fractional share investing allows investors to buy even a small portion of a share, making it easier to diversify their investments across all 30 companies in the index.

However, managing a portfolio of 30 separate stocks requires time and effort, as one needs to stay informed about each company's performance and make adjustments whenever the index changes its composition.

2. Options or futures contracts

Options and futures contracts offer more advanced investment strategies for experienced investors. Dow options contracts can be traded on the CBOE Global Markets options exchange, while Dow futures contracts are available on the CME Group's Chicago Mercantile Exchange.

Options give investors the right, but not the obligation, to buy or sell the underlying assets (in this case, the Dow Jones Index) at a predetermined price within a specific timeframe. Futures contracts, on the other hand, obligate investors to buy or sell the asset at a predetermined price and date in the future.

3. Dow-focused ETFs

Exchange-traded funds (ETFs) that track the performance of the Dow Jones Industrial Average, such as the SPDR Dow Jones Industrial Average ETF (DIA), provide a convenient way to gain exposure to all 30 companies in the index through a single investment.

By purchasing shares of the ETF, investors essentially own a diversified portfolio of stocks that replicate the index's performance. This approach simplifies portfolio management since the investor does not need to individually track or make changes when the companies listed in the Dow change. However, like any ETF, there is an annual expense ratio or management fee associated with it, which represents a small percentage of the investor's investment.

4. CFDs

Contracts for Difference (CFDs) provide a direct way to trade the Dow Jones Index. Traders can buy a CFD for stocks in the Dow Jones index and ETFs. CFDs are financial derivatives that allow investors to speculate on the price movements of the index without owning the underlying assets. By entering into a CFD agreement with a broker, traders can take long (buy) or short (sell) positions on the Dow Jones Index, depending on their market predictions.

CFD trading on the Dow Jones Index offers flexibility and the opportunity to potentially gain from both rising and falling markets, as the price of the CFD depends on the price of the Dow Jones Index.

Top 10 companies included in the Dow Jones Index

The Dow's composition is determined by a committee of editors from The Wall Street Journal and S&P Global. These editors bear the responsibility of deciding which companies are added to or removed from the index.

While there are no specific rules for inclusion, the committee follows general guidelines, considering factors such as a company's large market capitalisation, excellent reputation, and sustained growth. The top 10 companies currently included in the index are:

1. Apple: A technology giant known for its innovative products, with a market capitalisation of over $2.76 trillion and a strong 72.69% return on investment as of March 2023.
2. Microsoft: A global software corporation valued at around $2.37 trillion, recognised for its dominant presence in the tech industry and consistent growth in the market, with a 37.84% return on investment as of the first quarter of 2023.
3. Visa: A leading payment technology company boasting a market capitalisation close to $478.09 billion has given returns close to 34.43% as of March 2023.
4. JP Morgan Chase: One of the largest and most influential banking institutions with a market capitalisation of over $406.72 billion, the company is known for its extensive range of financial services and has given returns equivalent to 8.91% as of 2023.
5. UnitedHealth: A diversified healthcare company valued at approximately $445.80 billion has provided returns equal to 22.40% as of 2023.
6. Procter & Gamble (P&G): A renowned consumer goods company, valued at over $361.02 billion has given returns of more than 26.13% as of March 2023.
7. Walmart: A multinational retail corporation with a market capitalisation of over $404.36 billion has provided returns equivalent to 17.19% as of April 2023.
8. Johnson & Johnson (J&J): A leading healthcare conglomerate valued at around $412.96 billion, it has provided returns of around 14.53% as of March 2023.
9. Chevron: An energy corporation with a market capitalization of over $294.04 billion, recognised as one of the largest global oil and gas companies, it has yielded around 27.82% as of March 2023.
10. Home Depot: A prominent home improvement retailer valued at approximately $294.57 billion, it has given consistent returns of around 56.56% as of April 2023.

*Past performance is not a reliable indicator of future performance

Conclusion

The Dow Jones Index is affected by several factors, like rising/falling inflation, geopolitical tensions/relaxation, and global trade disputes. Investors closely monitor the Dow Jones Index as it provides valuable insights into the overall health of the US market.

By analyzing the index's performance, investors can gauge market sentiment, identify trends, and make informed investment decisions.