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Did You Hear If The Dow Was Up Today?

A common question for investors, right? Well, I have another one, "What is the Dow?"

To better understand the Dow Jones Industrial Average (better known as "the Dow"), you must first look at its history. The average started over 100 years ago, when Charles Dow, one of the founders of Dow Jones & Co., cobbled together a list of 12 companies that served as a proxy for the U.S. stock market.

Over time, stocks were added to the industrial average while some were eliminated and others substituted. In 1928, the industrial average was expanded to 30 stocks, where it stands today. By then proprietorship of the Dow placed in the hands of the editors of the Wall Street Journal (published by Dow Jones & Co.). The only surviving member of that inaugural season is General Electric.

At first the calculating was easy. All that had to be done was add up the closing price of each of the 12 stocks in the average and divide by 12. The result was the closing average of the Dow industrials for that day.

As time wore on the figure by which the tally of the closing prices was divided (the "divisor") had to be tweaked to maintain historical comparability. The divisor continues to be updated. Under the rules, the divisor is changed whenever a component stock splits, a company spins off an operating division, or when any of the companies that make up the average are replaced with other stocks. Under some circumstances, the divisor is changed if one of the companies pays out a dividend. The divisor is available in the Wall Street Journal in a chart in the Money & Investing section or at Dow Jones Indexes.

Today, the divisor is actually a fraction around 0.2. If, for example, the divisor stood at 0.20145268 then each one-point move in a component stock in the average translates into 4.96 points in the average. A characteristic that distinguishes the Dow from other popular market measures is that it is price-weighted. If, for example, on a given day, shares of Merck & Co. add five points while the other 29 stocks are unchanged, the Dow would record a gain of 24.08 points. And the same result would occur if Wal-Mart Stores Inc. gains five points while all the other stocks in the average are unchanged. For the purposes of the Dow, a point is a point, regardless of whether it comes from a high-priced stock or a more moderately priced issue.

By contrast, the Standard & Poor's 500 Stock Index, another market indicator, is a market-capitalization weighted index. The S&P index adjusts for differences in the relative size of its component companies. As a result, shares of GE, which has a market capitalization of more than $200 billion gets a relatively larger weighting in the tally of the S&P index than does, say, Adobe Systems Inc. with its market capitalization of around $3 billion.

Critics have long contended that the market-capitalization weighting of the S&P 500 index, and the broader snapshot of the market that that index gives, make it a better indicator of the market than the Dow. In fact, the Dow has shown to be as good as the S&P 500. Last year, both barometers rose more than 20 per cent. Despite the criticism about the Dow's narrowness or its stodginess, the two yardsticks, historically, have performed just about the same.

Regardless of what many investors think, size is not a strict criterion for inclusion in the Dow industrial average. These are not the 30 biggest companies in the U.S. In fact, PepsiCo and Ford are not included in the average. The Wall Street Journal editors who decide the composition of the average have seen fit to leave them out. Their rationale is that competitors stand as proxies for the businesses those two are in, General Motors Corp. for the auto industry, and Coca-Cola Co. for the food and beverage industry.

Choosing which companies to include, or when and which to substitute, is the part of the industrial average that is more art than science. There are no hard-and-fast criteria. Journal editors subjectively pick and choose from among all U.S. businesses to come up with a mix that attempts to reflect the country's corporate landscape. The 30 companies that compose the Dow industrial average are among the biggest, best-known, most highly regarded public companies in the world.

To learn more go to Dow Jones.

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