Thirty Stocks, One Divisor, and a Number Everyone Quotes

On May 26, 1896, Charles Dow published an index of twelve industrial companies. Today it holds 30, only one of which (General Electric, in since 1907) has been there through the whole run. The components have changed 48 times in 116 years, which makes the Dow less a fixed list of companies than a rolling snapshot of what American big business looks like at any given moment.

Why bring it up in July 2012? Because the Dow is the number newscasters read aloud on the evening news, and it is also one of the most misunderstood. Investors lean on it to take the market's temperature while rarely asking how the thermometer works. That matters when you hold a fund like DIA, which tracks the index directly, or when you try to judge whether a 150-point move is large or trivial.

The history is a little odd. The "Industrial" in the name is mostly a relic, since modern members include Microsoft, Cisco, Walt Disney, Travelers and Bank of America. Alcoa and 3M remind us of the original flavor, but the index now leans on finance, technology, health care and consumer brands as much as on smokestacks.

Dow Jones & Company's co-founder built the average to gauge the industrial sector. It has since become a stand-in for the entire American economy, a job its founder never meant it to do. Ownership has shifted too: the index now sits under Dow Jones Indexes, where the CME Group holds the majority stake. The CME Group controls about 90% of the indexing business and also runs the futures that trade on it.

Why a Price-Weighted Index Behaves Strangely

The Dow weights its stocks by price. Add up the share prices of the 30 stocks, divide by a number called the divisor, and you have the index. The divisor is not 30. Index managers adjust it whenever a component splits its stock or pays a stock dividend, or whenever they swap a component out, so that the index level does not jump just because of bookkeeping.

The practical consequence is that a stock with a high share price moves the index more than a stock with a low one, regardless of company size. A $200 stock that rises 1% adds far more to the Dow than a $15 stock that rises 1%. Market capitalization, the usual measure of how much a company is worth, plays no part.

Consider two hypothetical members. One trades at $190 with a modest market value, the other at $30 with a market value several times larger. In the Dow's arithmetic the first carries more than six times the influence per percentage move. In a cap-weighted index like the S&P 500, the second would dominate.

People often assume the Dow is therefore a poor guide. That overstates it. Over long stretches the Dow and the S&P 500 have moved together closely, because 30 giant companies tend to move with the broader market. The gaps show up over shorter windows, and they can be large when one high-priced stock has an unusual day.

A second misconception is that the index level means something by itself. A Dow at 12,700, roughly where it traded in mid-2012, says nothing about valuation. The number reflects 116 years of splits, replacements and divisor changes, so comparing levels across eras tells you more about arithmetic than about value.

What the Swaps Reveal About the Index

Every change in membership signals where the economy has moved. On February 19, 2008, Chevron and Bank of America replaced Altria Group and Honeywell. Chevron had been in the Dow before, from 1930 to 1999, and during its absence its split-adjusted share price rose from forty-four dollars to eighty-five while oil climbed from twenty-four dollars to a hundred.

That detail is worth sitting with. The index dropped an oil company near the bottom of the energy cycle and brought it back after a long run-up. Anyone who treated the Dow as a pure record of the best performers would miss that it sheds winners and losers alike, and the committee choosing replacements is judging representativeness, not momentum.

Later swaps follow the same logic. Kraft Foods joined in September 2008. Cisco and Travelers entered in June 2009. Pfizer and Verizon came in during 2004, and Microsoft, Intel, Home Depot and SBC Communications (now AT&T) all arrived on one day, November 1, 1999, at the height of the dot-com boom.

That last batch is instructive. Adding Microsoft and Intel, the first Nasdaq-listed names in the Dow, was an acknowledgment that an index of old-line industrials had stopped describing the economy. Critics noted the timing, since the tech additions landed within months of the market peak.

There is also a built-in survivorship effect. Because struggling members get replaced and strong ones tend to stay, the index looks better over long periods than a buy-and-hold of the original twelve would have. Dow history is partly a record of editing.

The Long Chart and What It Says About Patience

Our source material includes logarithmic charts running from 1790 to 2012, and the choice of a log scale matters. On a linear chart the 1929 crash looks modest next to the climbs of the 1990s, because a 10% drop at 100 is ten points and a 10% drop at 10,000 is a thousand. A log scale plots percentage change, so each move is shown at its true proportional size.

On that view, the long uptrend is plain, and so are the interruptions. From 1929 to 1932 the index fell roughly 89% from peak to trough, and it did not regain its 1929 high until 1954. From 1966 to 1982 it went nowhere in nominal terms. Between 2000 and 2011 the chart shows two sharp declines, the post-dot-com bust and the 2008 financial crisis, with a swift recovery from the March 2009 low near 6,500.

Those numbers support two different readings, and honest investors should hold both. Equities have rewarded patience across more than a century. Yet an investor who bought in September 1929, or in early 1966, waited decades for a real return. Time horizon is a hard constraint here, and a retiree drawing down a portfolio cannot wait twenty-five years.

We should treat the post-2009 recovery with some caution as well. Climbing from 6,500 to about 12,700 is nearly a doubling, which feels like safety but partly reflects how low the starting point was. Mid-2012 also carried real worries: the euro-zone debt crisis, a slowdown in emerging economies and doubts about American hiring.

Where DIA, MS, GS, MSFT and EEM Fit

For investors, the most direct way to own the index is DIA, the exchange-traded fund that tracks it. It holds the 30 stocks in proportion to price, mirrors the Dow's quirks, and pays out dividends monthly. A position in DIA gives concentrated large-cap exposure with a tilt toward high-priced shares, and no exposure to mid-caps or small companies at all.

Microsoft (MSFT) is the instructive component in July 2012. It joined in 1999, and for much of the decade after the dot-com peak its stock went sideways, trading in a band that left long-term holders frustrated even as the company produced large profits. Because it is one of 30 members and priced in the $30 range, its pull on the Dow is small compared with higher-priced names. An investor who wants a Microsoft view should buy Microsoft, not expect DIA to deliver it.

Morgan Stanley (MS) and Goldman Sachs (GS) are the contrast case. Neither is a Dow member, though JPMorgan Chase, Bank of America, American Express and Travelers are, so the index carries a meaningful financial weighting without the two best-known investment banks. If you hold DIA and add MS or GS, you are stacking more financial-sector risk onto exposure that already includes it. In 2008 those stocks fell far harder than the index, and the same leverage to credit conditions would show up again in any new shock.

Emerging-market funds like EEM sit at the other end of the diversification question. The Dow's 30 companies earn a large share of their revenue abroad, which means DIA already carries some global demand exposure, but it does so through American balance sheets and the dollar. EEM brings local-currency risk, different political risk and a very different sector mix, heavy on banks, energy and materials.

Consider a simple allocation of $100,000. Put $60,000 in DIA, $15,000 in EEM and keep $25,000 in bonds or cash. A 20% fall in US large caps costs $12,000 on the DIA slice, and if EEM falls 30% in the same episode (it fell far more than that in 2008) that is another $4,500. The total loss of $16,500 is about 16.5% of the portfolio, cushioned by the fixed-income slice. Swap the EEM stake for MS and GS and the correlation with the Dow goes up, not down, so the cushion shrinks.

Turning the Index Into a Working Tool

The first practical step is to stop reading the headline number as news. A "300-point drop" at a Dow near 12,700 is about 2.4%, a large day but not a rare one. Convert to percentages before reacting, and compare to the S&P 500 and Nasdaq Composite to see whether the move was broad or driven by a few high-priced stocks.

Second, decide what DIA is for. If the aim is cheap exposure to large, established dividend payers, it fits. If the aim is to track the whole US market, a broader fund covers more ground, since DIA ignores everything outside its 30 names and weights them by an accident of share price.

Timing questions come up constantly, and the evidence favors modesty. Because the 1929 and 1966 episodes both began after long advances, people sometimes conclude they can spot tops. In practice the same charts show countless false alarms. A fixed schedule, for instance buying equal dollar amounts monthly, avoids the problem of choosing the moment, and it buys more shares when prices are low.

Rebalancing deserves a rule too. If DIA grows from 60% to 70% of the portfolio after a strong year, trim back to target. That forces a sale after gains and a purchase after declines, which is uncomfortable in practice but is the point of the exercise.

Implementation hurdles are mostly behavioral. Investors who own DIA often add individual names like MS, GS or MSFT because they have a view, and the result is a portfolio whose true exposure to financials or technology is far larger than intended. List every holding, look through to the sector weights, and add up the pieces before adding anything new.

Derivatives exist on the Dow too, with options on the CBOE and futures through the CME Group. Most readers will not need these, and the futures still matter because they trade nearly around the clock and often signal the opening direction. Watching them is useful context, not a trading plan.

What We Would Do With This Information

The Dow is a good historical record and an imperfect measure. It is price-weighted, it is edited by a committee, and its 30 companies cannot stand in for an economy of millions of firms. Still, it has tracked broader markets closely enough over the long run that ignoring it would be foolish.

Several steps follow from that. First, check what DIA contains and compare its sector weights to your other holdings. Second, if you hold MS or GS alongside it, calculate your combined financial exposure and decide whether that level was a choice or an accident.

Third, if EEM is part of your plan, size it on its own risk and not on the hope that it offsets US stocks, since in a global sell-off the two tend to fall together. Fourth, write down a rebalancing rule before the next big move, while you can think clearly. A 5-percentage-point drift from target is a common trigger.

Finally, keep a long view of the charts without treating them as a promise. Roughly a century of data shows that equities compound, and that the path includes a 89% drawdown, a lost decade in the 2000s and a quarter-century of waiting after 1929. Match your holdings to the years you can afford to wait, and the daily headline number matters a lot less.