The Dow Jones industrial average is the most widely recognized barometer of American financial health in the world and is often thought to reliably indicate trends in the entire market. But despite the Dow's high profile, it is considered of dubious value by some investors, who feel that it fail to mirror the broader American economy. For one thing, the Dow contains just 30 stocks, a number too small to represent the more dynamic economy at large.
The Dow is called an “average” because it originally was computed by adding up a number of stocks and dividing by that number. Founder Charles Dow first tabulated the average in 1896 by adding up the stock prices of 12 leading companies of his day and dividing by 12. Today the 30 companies that make up the Dow are chosen by the editors of the Wall Street Journal. The list is updated every few years, but its composition remains weighted toward large industrial companies rather than the service industries that create all the wealth in today’s economy.
Unlike any other major market index, the Dow is “price-weighted,” meaning that companies with the highest-priced stocks are the most influential. A $1 move in a $100 dollar stock is only a change of 1 percent for that company, not an unusual occurrence, whereas a $l move in a $10 stock would be a change of 10 percent and a major event. However, as the net change is the same in both cases, the movements are reflected equally on the Dow.
As a result, smaller complains on the index can have a disproportionately large impact if their stock prices happen to be high. For example, fluctuations in the fortunes of the $49 billion 3M company have a comparatively larger effect than changes in the $230 billion General Electric Company simply because 3M's stock is worth more than four times that of General Electric.
In contrast, other indexes-such as the popular S&P 500-are “market capitalization-weighted.” The influence of a company’s stock on these indexes depends not only on the price of an individual share but also on the total value of all the company's shares on the market put together.