What is the Dow Jones Index: how to calculate, where to invest and which stocks to buy on FxPro
Table of Contents
- How the Dow Jones Index came to be
- The first Dow Jones Index
- Composition of the Dow Jones Index
- Companies in the DJIA Index
- How the value of the index is calculated
- DJIA: comparison with other US indices
- How to invest in the DJIA
- Adding stocks to your portfolio directly
- Index futures
The Dow Jones Index or DIJA is based on the current quotations of 30 securities of selected industrial companies of the New York Stock Exchange.
You have probably heard of it even from non-economic newscasts. The DIJA determines the health of the United States economy as well as the course the Federal Reserve is on. This index is a litmus test of the main financial processes in the country. If the blue chips (the largest companies in its composition) are doing well, it means that the country's economy is in a healthy state, or is successfully recovering from the crisis. Otherwise, it is one of the clearest indicators of upcoming or ongoing problems.
How the Dow Jones Index came to be
At their core, indices like the DJIA track the prices of a specially selected group of stocks. A specific industry, market or even the entire national economy is modelled in this way. There are indices for almost everything, from those that show the general situation of the stock market and world bond markets, to the gold market.
The very first DJIA was calculated in 1896 by American journalists C. Dow and E. Johnson, co-founders of the financial news agency Dow-Jones and Company. They wanted to clearly demonstrate to their readers what was happening in the national economy right now.
The first Dow Jones Index
By the way, the DJIA was the second index that was ever calculated at all. The first one, however, was from the same team. It was called Dow Jones Transportation Average and was born in 1884.
Initially, the Dow consisted of only a dozen corporations from the gas, sugar, tobacco, railway and oil industries. The index then evolved, expanding to 30 issuers, including all major industrial sectors. The composition has also changed over the years, with stocks being added and dropped, which is still the case today.
Composition of the Dow Jones Index
In the table below, you'll see the 30 companies whose stocks are included in the Dow Jones Industrial Average in 2021.
On average, one company is removed and replaced by another about every two years. Most often, this happens because a company's importance or influence in its industry is significantly diminished.
Companies in the DJIA Index
|American Express Company
|Cisco Systems Inc.
|Goldman Sachs Group, Inc.
|Home Depot Inc.
|Honeywell International Inc.
|International Business Machines Corporation
|Johnson & Johnson
|JP Morgan Chase & Co.
|Merck & Co. Inc.
|Procter & Gamble Co.
|Travelers Companies Inc.
|United Health Group Inc.
|Verizon Communications Inc.
|The Walt Disney Company
|Walgreens Boots Alliance Inc.
How the value of the index is calculated
When the Dow Jones Industrial Average was first launched, it was calculated by summing the price per share of each company within it. The resulting number was then divided by the total number of issuers. Now, however, a more complicated formula is used to determine the average value of the index.
One of the biggest difficulties in calculating the index is that some companies are more heavily weighted than others. Dow Jones adjusts for this by using a weighted average price. This means that particularly expensive stocks have a greater impact on the index than less expensive securities. Thus, the weighted average price ensures that one stock does not drive the index too high or one security does not pull the Dow Jones down too much.
The value of the Dow Jones is supposed to be faithfully represented by all thirty companies in its composition, so one company should not have a significantly greater advantage and influence on the quote than another.
DJIA: comparison with other US indices
Although many economists focus on this index, they still take into account other U.S. stock indices, which include many more securities:
- Standard & Poor 500 (500 large-cap stocks on several exchanges);
- NASDAQ 100 (100 large-cap stocks on NASDAQ);
- Russell 1000 (1,000 large and mid-cap stocks on the NYSE and NASDAQ.
For this reason, it is believed that the Dow cannot serve as an accurate benchmark for evaluating the U.S. economy as a whole. Given the small number of companies, each can easily be a full-fledged representative of its sector.
Remember, for example, Apple's 4-to-1 stock split, which upset the Dow's "apple basket" and forced the index to replace three companies at once in order to maintain balance.
Another major criticism from economists has to do with the fact that the DJIA is price-weighted. This means that its average is based only on the stock price of its component companies. Other major indices, like the S&P500, take capitalisation into account: they value a company by multiplying the current price of the securities by their number of outstanding shares, which more reliably reflects the market picture.
How to invest in the DJIA
Let's say that the index is a rating indicator, you cannot invest directly in it, there is simply nowhere to invest. But there are a lot of assets interrelated with the Dow Jones that can be used for investment and speculation.
Many investors choose index funds based on the Dow Jones Index. When you buy one share of such a fund, your portfolio gets access to all 30 components of the Dow. This gives you the opportunity to invest in companies that have a proven track record and solid business prospects.
Adding stocks to your portfolio directly
Traders most often think of a strategy called Value Investing or Dogs of the Dow in this case. The system is based on the following: you buy stocks from the Dow with the highest dividends on the assumption that these securities are undervalued. The prospects aren't bad: since 2010, the average annualised return of the Dogs of the Dow methodology has been 15.9%. Past performance, however, is no guarantee of future gains.
A more economical way to invest in the DJIA is to buy an index fund that contains all 30 Dow stocks, which reflects the actual index.
As for ETFs, the Rydex Dow Jones Industrial Average Funds (RYDAX, RYDKX, RYDHX) invest more than 80% of assets in the Dow 30 Index, with the rest divided between derivatives and cash. All three funds require a minimum initial investment of $2,500, with fees starting at 1.70%.
Dow futures begin trading on the Chicago Mercantile Exchange at 7:20 a.m. central time. Because Dow futures trade an hour and ten minutes before the stock market opens, the investment community and financial reporters get an idea of the overall market sentiment.
If Dow futures are trading lower, it is likely that the stock market will also open lower. The opposite is also true: If Dow futures are trading up, it is likely that stocks will also go up at the opening of the U.S. session. Traders often use this information to open positions not only in the futures market, but also in individual securities. Of course, this does not guarantee 100% scenario fulfilment.
You can trade on price fluctuations by opening trades in the CFD contract format, or even set up a robot on an index chart. Many traders like to trade the Dow Jones Industrial Average (DJIA) because of the high volatility of the US markets.
Before you start trading, you need to study the charts and analyse the market to try and predict the direction the index will take.
Even though there are only 30 companies, you should not try to analyse each one individually. The Dow responds well to technical analysis and works as a composite price. You can watch the price find support and resistance in whole numbers such as 10,000, 11,000 and 1,000.
The Dow Jones Index is unique and certainly popular. Its importance is primarily due to the fact that it represents and reflects the market movements of giants like Microsoft, Boeing, IBM and Coca Cola.
It may not include as many stocks as some other indices, but it does have a choice: a representative cross-section of America's major corporate players. And, as noted above, the list changes periodically to reflect the rise or fall of various sectors.
Historically, the DJIA's performance is very close to that of the entire stock market. Thus, in the eyes of analysts and investors, the Dow Jones Index reflects the state of affairs in the entire world of equities.