Dow Jones Industrial Average - Essay Sample

The Dow Jones Industrial Average (DJIA) is an index used an indicator of the performance of the stock market and the economy. It comprises 30 companies drawn from various sectors including industrial and consumer goods manufacturing, information technology, financial services and entertainment. The DJIA is the quotient of the sum of the share prices of the firms making up its components and the Dow divisor, with the Dow divisor being a constant value that currently stands at 0.14602128057775. To ensure that the DJIA is accurate in representing the state of the stock market, the Dow Divisor is normally adjusted for corporate events that are likely to affect the DJIAs numerical value; such corporate events include, among others, spinoffs and stock splits.

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The DJIAs history dates back to May 26, 1896 when Charles Dow computed the inaugural average of industrial stocks. The initial average comprised 12 stocks, majority of which were railroad companies. The unveiling of the average made it easy to distinguish long-term and short-term developments in the stock market. Apart from General Electric, none of the companies that made up the first DJIA form its components today. Some large U.S companies descended from the firms that were included in the first DJIA. Two decades after the publication of the first DJIA, the index expanded to include 20 stocks. The DJIA expanded again in 1928 to include 30 stocks. The enlargement in the indexs constituent stocks necessitated a change in the computation of the average; the divisor, rather than the number of stocks, started being used to forestall distortions that result from corporate events.

A remarkable moment in the DJIAs history was in early 1906 when the index surged past 100 for the first time. However, the index did not maintain the momentum that had seen it surge past the 100 mark; it fluctuated between 53 and 103 points until the end of 1914. The economic crisis preceding the Great Depression exacted a heavy toll on the DJIA considering that it dropped 90% to stand at levels below the peak in earlier periods. Problems in the global economy in the decade to 1940 eroded the phenomenal gains of the 1920s; the DJIA lost up to 170% in this period (Charles and Darne, 2014). A bull run that began in the early 1950s saw the DJIA increase by 200% to stand at 616 by the year 1960 which, considering the changes in the global economy caused by political developments was a stark difference from the preceding decade.

The growth in the DJIA would later slow through the 1960s and 1970s. The index increased 30% in the years to 1970, and less than 5% in the decade to 1980. The dotcom bubble fuelled stock market growth to levels never seen before. In the last decade of the 20th century, the DJIA gained at least 315%. The impressive growth during the dotcom bubble would plummet to -7% by the end of the first decade of the 21st century. Important recent developments include the surge of the DJIA past the 18,000 mark in 2014. The index defied analyst predictions of a slowdown following last years presidential election and registered a new high. The DJIA has several shortcomings though.

At least 5,300 companies have their common shares trading on the New York Stock Exchange (NYSE), yet the DJIA only comprises 30 companies. In addition, while the companies in the DJIA operate in the leading sectors of the economy, some sectors are not represented in the index. Therefore, the DJIA is not representative of the stock market, which makes it an inappropriate yardstick for gauging the performance and trends of the stock market and the economy. It would be better if the DJIA comprised at least 25% of the companies trading in the NYSE. While enlarging the number of companies comprising the DJIA would increase computational difficulties, it would result in an index that is better at capturing important developments in the economy and the stock market.

The DJIA is a price-weighted index, which implies that its components do not have the same influence on its numeric value (Ivanov, Jones, and Zaima, 2013). For instance, suppose there are two firms in the DJIA, company A & B. Assuming that at a given point, company A is trading at $157 per share while company B is trading for $52 per share, a change in the share prices of the two firms by the same margin would have a different impact on the DJIA. The impact of a dollar increase in the share price of firm A on the numerical value of the DJIA would be at least three times as much that of a dollar increase of company Bs share price. The shortcoming of the price-weighting of the DJIA has resulted in the wide acceptance of indices that use broader and market-cap weighting in assessing the performance of large corporations. Users of the DJIA should consider its shortcomings when using it as a guide in making investment decisions.

References

Charles, A., & Darne, O. (2014). Large shocks in the volatility of the Dow Jones Industrial Average index: 19282013. Journal of Banking & Finance, 43, 188-199.

Ivanov, S. I., Jones, F. J., & Zaima, J. K. (2013). Analysis of DJIA, S&P 500, S&P 400, NASDAQ 100 and Russell 2000 ETFs and their influence on price discovery. Global Finance Journal, 24(3), 171-187.