What Is the Dow Jones Index?
Large companies inevitably affect the entire economy, especially when it comes to the top blue-chip companies. By combining and tracking stocks of these companies, traders can get a good view of how the American market is performing as a whole. This is the exact reason the Dow Jones Industrial Average (DJIA) index exists.
Let's see what makes the Dow Jones one of the most well-known stock market indices, how the index is constructed and calculated, and what you should know before trading on it. Additionally, we will take a more in-depth look into what makes it an attractive investment tool and what drawbacks you need to be aware of.
Dow Jones Industrial Average Definition
The Dow Jones Industrial Average, often referred to as ‘the Dow’, is an index consisting of 30 well-established and financially sound U.S. companies. It serves as a benchmark for stock market performance and sentiment.
Initially, the index listed just 12 companies. These days, the Dow Jones has 30 components from all major sectors of the economy, except for transportation and utilities. There aren't any strict rules of what companies are eligible to be included. But the primary condition is to be a publicly-owned company listed on the NASDAQ and the New York Stock Exchange (NYSE).
Understanding the Dow Jones Industrial Average
The DJIA is the second-oldest U.S. market index, following the Dow Jones Transportation Average from 1884. At the time of its inception in 1896, the Dow Jones Industrial Average reflected the performance of companies only within heavy industries, like oil, machinery manufacturing, and construction. The name and composition were decided by the editors of the Wall Street Journal.
Over time, the name transformed into something remote from its original meaning. Very few Dow Jones companies are related to industrial goods. Now, it mostly acts as a measure for the activity of the biggest companies on the U.S. market, as stated previously. The top 10 companies within the index include:
|Boeing||Aerospace & Defense||7.822828|
|UnitedHealth Group Incorporated||Healthcare Facilities & Svcs||6.864806|
|Goldman Sachs Group Inc.||Institutional Financial Svcs||5.499355|
|Home Depot Inc.||Retail||5.155293|
|Visa Inc. Class A||Specialty Finance||4.485476|
|United Technologies Corporation||Aerospace & Defense||3.594108|
How Is the Dow Calculated?
The Dow 30 is price-weighted, which means the member companies are weighted based on their price per share. Higher-priced stocks have a more significant impact on the lower-priced ones. For example, if the issuing company's stock is $100, it will be weighted more than a $50 stock.
This method is contrasted to weighing by market capitalization of the index constituents. Examples of capitalization-weighted indices include the S&P 500, FTSE 100, Nikkei 225, and other major ones.
Share price weighting has some downsides, and it raises the question of whether it is just a holdover from the past. Share price mostly dependents on the volume of issued shares. To put it simply, it mostly measures the cake by the number of slices, rather than how big it is.
This is the reason why DJIA 30 is not the true average of its constituents. The resulting index is calculated with a special divisor, which initially was taken arbitrarily. To ensure the continuity of the Dow index, the divisor adjusts to component the stock structural changes.
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