Suppose you and your family are returning from a week-long vacation at Disney World. You confirm your flight by cell phone. After you arrive at the airport, you open your laptop to check email while waiting at the gate. Once you are at 30,000 feet, the flight attendant comes by with snacks and a soft-drink. Three hours later you’ve landed in Portland, Maine, jump into your car, stop at the ATM, fill-up the gas tank, and grab burgers and fries for the family. Before heading home, you swing into a “big box” retailer to pick up milk, aspirin, and detergent. Finally, you arrive home, tuck the kids in bed, upload your photos onto the digital picture frame and call it a night.
During the past eight hours you have supported at least 15 of the largest companies in the world, which are part of a stock market index known as the Dow Jones Industrial Average (DJIA), large corporate names that include Disney, Verizon, Microsoft, Coca Cola, Kraft, and Bank of America to name a few. The DJIA, often referred to simply as the Dow, affects all our lives every day, yet most of us know very little about it. What is a stock market index? What is the origin of the Dow? How has it evolved? Who is in the “club”? How is the Dow calculated? What does the Dow mean to the common person?
Let’s start by defining a stock market index. This index represents the stock market (publicly traded companies) as a whole, based on the performance of a smaller group of companies. Arguably, the most closely watched stock market index is the Dow Jones Industrial Average. In 1883, former fellow journalists for the Providence Evening Press, Charles Dow and Edward Jones, teamed up to create a printed report of the daily financial news, the Customer Afternoon Letter. This report quickly grew in popularity and eventually led to what many consider the world’s most prolific business news resource–The Wall Street Journal. Charles Dow selected a small group of diverse industrial companies to represent the stock market as a whole. Hence, the Dow Jones Industrial Average was born, consisting of just 12 companies. Over time the Dow has grown to 30 companies. The Wall Street Journal (WSJ) editors of today periodically revise the list of companies to determine those which best represent the stock market.
Yes, there’s some math involved in understanding the DOW. Don’t sweat it though, as the DJIA is calculated using a simple fraction. The Dow Jones Industrial Average was initially calculated by simply adding up the closing stock prices of the 12 companies in the index and dividing by 12. I think you would agree that’s pretty straightforward. On its first day in existence, May 26, 1896, the sum of the closing stock prices of the 12 Dow companies was 492. Divide that sum by 12 and you have a closing index of 41. Let’s say the next day the DOW closed at 42. That means the index rose two percent (1/41) from the prior day. Over the years, the formula for calculating the Dow index has become more complex because of something called stock splits. These splits now determine what the divisor will be, but that is the topic of a future article.
Here’s how the DOW affects you: In July 2011, the Dow hovered around 9,700 and has since risen about 30% to its current level of around 13,000. What does this mean to you, the investor? Assuming your investment closely mirrors the DJIA index, your employer sponsored retirement plans, mutual funds and individual stocks have likely risen about 30% since last July. Thus, if you had $5,000 invested in the stock market in July 2011, your portfolio would have grown in value to approximately $6,500, a 30% increase in May 2012.
There are many other indices (indexes), such as the Standard and Poor 500, Russell 2000 index and Dow Jones Utility Average, which represent the performance of similar companies in those indices. That being said, the Dow continues to be the most watched index by investors around the world. Surely Charles Dow could never have imagined that the index he created from the back room of a lower Manhattan building over 100 years ago, would be part of our daily lives, as people take in the financial news on their televisions, cell-phones or laptops.
Trivia Question: Today, there is only one company included in Dow Jones Industrial Average that was also included in the original index. Can you name the company?
Click on the video above to watch a three minute tutorial showing the Dow companies, how to calculate the DJIA and the answer to the trivia question. You can send questions or comments to Giordano@maine.edu.
Tom Giordano (Prof. G) is an Assistant Professor of Accounting at University of Maine at Augusta. . You can read his column on the 1st Sunday of the month in the Business Section. Prof. G’s next article will get right down to the basics: What is a stock anyway?