How to Understand the Dow Jones Index

When someone refers to the "Dow Jones index" or "the Dow Jones" or "the Dow," that person is invariably referring to the Dow Jones Industrial Average. The Dow is the most commonly reported business statistic, and the news media tend to interpret the fluctuations of the Dow as representative of the economy as a whole. For all the attention paid to the Dow, however, this "magic number" is little understood away from Wall Street. To understand the Dow Jones industrial average, you need to know what it measures -- and what it doesn't measure.

Recognize what it does and doesn't measure. The Dow really only measures one thing: the collective health of the 30 companies in the index. There is often a correlation between the Dow and the state of the U.S. economy. After all, if the economy is booming, these market-leading companies will be, too. But the economy is vastly larger than these 30 companies, and the Dow does not take into account the thousands of other publicly traded companies, as well as the millions of small, privately held businesses.

The limited breadth of the Dow can actually present a distorted view of the economy. To take an extreme scenario, imagine if Home Depot successfully ran every other hardware store out of business. That could have a devastating effect on local retail economies -- but it would send Home Depot stock skyrocketing, taking the Dow up with it.

Know how it's figured. When Wall Street Journal publisher Charles Dow created the Dow Jones Industrial Average in 1896, it was calculated simply by adding up the share prices of the companies' stocks and then dividing by the number of companies (at the time, 12). As its name implies, it was the average price of the stocks. The total share price is no longer divided by the number of companies (which would be 30), but rather by a number called the Dow Divisor, which is regularly adjusted to account for stock splits, dividends, and other factors. As of November 2009, the Dow Divisor was about 0.1323.

Accept its importance. Despite its limitations, the Dow has a powerful psychological effect on markets around the world. When the Dow is up, investor confidence rises, and that can buoy the economy as a whole. When it's down, the opposite often happens. Informed investors, however, will find ways to profit regardless of which way the Dow is moving.

Understand what goes into the calculations. The Dow Jones Industrial Average is based on the stock prices of 30 major U.S. corporations. The Dow 30 companies are all leaders in their industries, including manufacturing (Boeing, Caterpillar), consumer products (Johnson & Johnson, Coca-Cola), pharmaceuticals (Merck, Pfizer), high technology (Microsoft, Intel), financial services (American Express, Bank of America), retail (Wal-Mart, Home Depot) and entertainment (Disney).

Difficulty: Moderately Easy