Through the 119-year history of the Dow Jones Industrial Average, the US index has become a benchmark for the markets. Numerous investors worldwide monitor the DJIA or the Dow – as simply known - at the end of every trading day to get an overview of the markets’ performance. But do they really know what the index is all about? Studying the history and mechanism of DJIA is crucial to understand what the index is telling us every day.

Read on to see how this mighty index turned out to be world’s most widely tracked measure of stocks.

The Dow is up, the Dow is down…

Daily market outlooks just wouldn’t be complete without a report about the open and close of the Dow Jones Industrial Average. But although you’ve certainly read commentaries about the index being up or down a certain number of points, do you really know what these points stand for and what these changes mean for investors?

The Dow Jones Industrial Average is:

A weighted index of the market price of the 30 largest publicly-traded companies on the New York Stock Exchange. All of these stocks are big American blue chip companies. A blue chip is a stock in a company with large market capitalization, stable earnings history and a reputation for reliability, quality and profitability. The day-to-day movements of the DJIA index are closely monitored by professional analysts and individual investors, as its components dictate the movement of the entire stock market.

What does it mean for investors?

Say that James trades in the stock market. James owns various large cap stocks including Apple Inc. (AAPL), McDonald’s Corp. (MCD) and Visa Inc. (V). He would like to know how the stock market performed during the day. James could spend the time to read the stock price of all these companies or he could just look at the DJIA. The DJIA would help him get an idea of the stock market movement. In case the index closed up, this means it was a good day for the market and James’ portfolio probably rose in value. In case that it closed down, then it was a bad day for the stock market and James’ portfolio probably fell.

Now that we’ve set out what the index is and what it means for investors, let’s take a look into its composition to understand how it works.

The history of Dow

Before the creation of the Dow Jones Industrial Average in 1896, investors had no way of identifying trends in the overall market. They couldn’t tell whether the market was bull or bear. Charles Dow had the vision of summarizing the stock market with one easy to understand number that could help investors make informed decisions. He achieved this by picking the 12 stocks he thought best reflected the American economy at the time. By giving investors a simple and reliable tool, which helped them to consistently measure market movements, Dow changed the history of investing for ever.

In 1916, the Dow expanded to 20 stocks and in 1928 to 30 stocks, reflecting this way the vast growth in the US economy. Although the economy of the country has grown considerably since 1928, the Averages Committee - which makes the decisions about the components of the index – chose to keep the number of companies at 30. This is because the number of stocks is not considered as important, as the actual stocks being selected. The number could be raised to 50 or 100, but unless the mixture of companies was right, the index would not work as a market barometer.

The Dow Divisor

Over the years, components of DJIA have been changed to make sure that the index stays in line with the standards of the US economy [in fact, General Electric (GE) is the only stock of the original 12 still in the index]. The financial landscape also changed, thus making the calculation of the index a bit more complex than just adding up the stocks and dividing them by 30. After all, Charles Dow lived in times when stock dividends and stock splits were not common practice, so he couldn’t predict how these actions would affect the average.

To put that in context, consider that if a company that trades at $50 makes a 2-for-1 split, the number of its shares will double and the stock price will become $25. This change in price will weaken the average, despite the fact that there is no fundamental change in the stock. In order to eliminate this phenomenon and maintain price continuity, the Dow divisor was introduced. The Dow divisor is a number adjusted to consider events like stock splits and prevent any change from affecting the index.

How does the Dow divisor work?

To calculate DJIA, you add the current prices of the 30 stocks comprising the index and then divide the number by the Dow divisor. Let us assume that the DJIA is composed of 30 stocks, totalling $3,000 when their stock prices are added together. The DJIA quoted will, thus, be 100 ($3,000/30). Mind that the divisor in our example is 30.

Now, suppose that one of the stocks in the index trades at $300, but undergoes a 2-for-1 split, and its stock price falls to $150. If our divisor remains unaltered, the calculation would give us 95 ($2850/30). This, though, would be inaccurate, as the stock split changed the price and not the value of the company. To absorb the effect of the split, the divisor needs to be adjusted downwards to 28.5. This way, the DJIA remains at 100 ($2850/28.5) and reflects more accurately the value of the stock.

Each change in the components or a stock split requires a new divisor. As of the 23rd of March 2015, the current divisor to account for the addition of Apple is 0.14985. To calculate how a change in a particular stock affects the DJIA, divide the stock’s price change by the current divisor. So, if Merck & Co. Inc. (MRK) is $5 up, divide 5 by 0.14985, which equals to 33.37. Therefore, if the index was up 100 points during that day, MRK was accountable for 33.37 points of the move.

Price-weighted index

The methodology of calculating DJIA is the price-weighted method. This means that the influence of each stock on the index depends on its price. The most expensive stocks move DJIA much more than the least expensive ones. The implication of this method is that a less expensive stock with a larger market cap has less weight on the index than a stock with a higher price, but smaller market cap. Another implication is that this method does not reflect the fact that a $2 change for a $20 stock is way more important than a $2 change for a $200 stock.

The Averages Committee argues that it would not be wise to change the price-weight method to market-cap, a method employed by most other indices, since that would ruin comparisons with historical DJIA figures based on price-weighting. In addition, market-cap weighting could make the index more prone to investing fads like the 1990s’ dot-com bubble.

The savvy investors’ favourite

Monitoring the Dow Jones Industrial Average will surely give you an edge in your trading endeavours, as it is one of the most-watched indicators for stock market performance. After almost 20 decades of being a maker of major market developments, the DJIA is still one of the most recognised and easy to calculate market indices of all.