One hundred and twenty years after its birth, the Dow Jones Industrial Average is as relevant as ever. There’s hardly a news story about the American stock market that doesn’t mention the index’s industrial average.
The idea of the Dow, an index of stock prices of 30 highly-valued and influential American companies, was first conceived by Charles Dow and Edward Jones, two financial journalists who went on to become the founders of The Wall Street Journal. Understandably, a lot has changed since 1896. The original 12 companies that made up the Dow, save for General Electric, have all disappeared from the index. At the time, those companies represented that era’s major economic outputs: sugar, energy, rubber, steel, and leather.
Also, at first, the Dow contained only industrial stocks (hence the name), and back then, investors were actually mostly interested in bonds. As financial historians note, the Dow became increasingly important over time, and by the 1950s, everyday Americans began to invest in stocks, as opposed to just professional traders.
The Dow has had an iconic presence in American financial markets. Over the course of its 120 years of existence, to what extent has it reflected the nature of the U.S. economy at large?
On the one hand, the 30 stock components in the Dow have a combined market capitalization of over $5 trillion, which make up 20 percent of the market value of all U.S. stocks. So even though the Dow isn’t the entire stock market (which is not the economy anyway), it’s meant to say something about the entire market. Further, the types of companies in the Dow have always been reflective of the changing nature of what America creates: from industrial production at the turn of the century, to the rise and fall of American manufacturing, to tech companies such as Intel and Microsoft in the 1990s.
Naturally, some argue that in only following the value of 30 companies, the Dow can’t possibly offer insights into the health of the entire American economy. And that’s how the limitations of the Dow come into play: It only tracks the winners, not the losers. The companies in the index are chosen by editors at The Wall Street Journal, and companies are removed as they become less relevant.
“The Dow is hardly a history of the U.S. economy. It is an index—unweighted—of the stock prices of a small number of America's largest corporations selected to represent the leading firms at particular times in our economic history,” explains Richard Sylla, a professor of economics at NYU’s Stern School of Business who studies the history of financial institutions. “Firms are removed from the index when thought to be less representative of corporate leaders, and replaced by ones thought to be more representative. This tends to make the economy to look better than it actually is.”
The purpose of the Dow remains the same as it was 120 years ago, but these days, other indexes—such as the S&P 500 (owned by the same company as the Dow since 2011) and the Russell 2000—are thought to be better representatives of what’s going on in the American stock market. Critics have gone as far as calling the Dow’s importance an accident of history—in the sense that an index of 30 companies only made sense at a time when indexes were calculated by hand.
Sylla says that the Dow remains popular because it is the oldest index, and it remains highly correlated with other indexes. It seems unlikely that anyone following the market will stop referring to the Dow anytime soon, though—not only has it become a habit of how Americans talk about the U.S. economy over the last century, it also speaks to another American pastime: tracking the winners.