Why the Dow Jones Industrial Average moves markets

The Dow Jones Industrial Average was introduced on May 26, 1896, at a time when bonds were the investment of choice among investors and stocks were warily regarded. That was a perception that Charles Dow, co-founder of the Wall Street Journal and Dow Jones Newswires, wanted to change. So he created the stock index.

Dow's intent was to give investors a method of measuring stock market performance over time, which until then had been lacking. "He compared his average to placing sticks in the beach sand to determine, wave after successive wave, whether the tide was coming in or going out. If the average's peaks and troughs rose progressively higher, then a bull market prevailed; if the peaks and troughs dropped lower and lower, a bear market was on," according to a Dow Jones history.

The Dow launched with 12 stocks—including cotton, sugar, tobacco, cattle companies and General Electric (still in the Dow today)—at an index reading of 40.94. Beginning in 1908, Arthur "Pop" Harris took over for Charles Dow in calculating the index every day—and stayed on the job for 40 years.

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"On busy trading days, he sometimes bloodied his hands pulling out the ticker tape. Through all those years, the financial world would hold its breath for seven minutes after the New York Stock Exchange's closing bell, waiting for Pop, who was a small, skinny man, to finish his official calculations on a piece of newsprint," according to the Dow Jones history of the index.

The Dow Jones Industrial Average expanded to 20 stocks in 1916, then to 30 in 1928—the same number as today.

The 30 stocks in the Dow are selected by a committee comprised of the WSJ editor-in-chief, Gerard Baker; WSJ Money & Investing section editor, Francesco Guerrera; and S&P Dow Jones Indices managing director David Blitzer, director David Carlson and senior director Craig Braswell.

The DJIA is reviewed at least once annually. There are no quantitative rules for component selection, but Dow Jones states that "a stock typically is added only if it has an excellent reputation, demonstrates sustained growth, is of interest to a large number of investors and accurately represents the sector(s) covered by the average."

The Dow is not an index quick to change its 30 components. Most changes to the DJIA result from merger activity, though at times—as in the case of Apple's addition to the Dow planned for March 18, 2015—stocks are added and stock replaced to make sure the Dow is representative of the broad market. The Dow covers most major sectors of the market, with the exception of transportation and utilities, which have their own Dow averages.

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Charles Dow first began toying with a railroad index in 1884 because the sector represented the largest national companies of his day. Since then, the DJIA has seen one-time giants, including Bethlehem Steel, Westinghouse Electric and Woolworth, give way to Hewlett-Packard, Johnson & Johnson, Microsoft and Wal-Mart Stores—and Hewlett-Packard give way to other companies itself in 2013.

In announcing that Apple would be added to the index, David Blitzer, managing director and chairman of the index committee at S&P Dow Jones Indices, said, "The DJIA is price-weighted so extremely high, stock prices tend to distort the index while very low stock prices have little impact. Apple's split brought the stock price down closer to the median price in the DJIA." Apple most recently split its stock in June 2014.

AT&T, which Apple is replacing, had one of the lowest prices among Dow stocks.

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Other recent notable changes to the Dow include the replacement of Alcoa (which had been in the index since 1959) and Bank of America, and the addition of Visa and Nike, at the same time that HP was removed in 2013.

Visa, and the DJIA structure, also played a role in the Apple addition. Visa's 4:1 stock split scheduled for the same date as the Apple introduction to the index will result in a lower stock price for Visa, and that will reduce the weighting of the information technology sector in the index.

Unlike the index, which is market-cap weighted, the Dow is a price-weighted index; that is, the stocks with the highest share price have the greatest weight, and impact, and the Apple move is intended to minimize the impact of the Visa split while also keeping the weighting of information technology consistent.

The first step in calculating the Dow is the same today as it was in 1896—adding up all the stocks in the index, and dividing by a divisor. That divisor has gone down significantly over time due to stock splits, spinoffs and substitutions in the index—the divisor was originally equal to the number of stocks in the average to provide an average stock price.

Dow Jones explains why the divisor has gone down over time this way: "Say three stocks are trading at $15, $20 and $25; the average of the three is $20. But if the company with the $20 stock has a two-for-one split, its shares suddenly are priced at half of their previous level. That's not to say the value of the investment has changed; rather, the $20 stock simply sells for $10, with twice as many shares available. The average of the three stocks, meanwhile, falls to $16.66. So, The Dow divisor is adjusted to keep the average at $20 and reflect the continuing value of the investment represented by the gauge."

The current DJIA divisor is 0.15571590501117.

For the first half of the 20th century, the DJIA was the primary benchmark for trends in the stock market, until S&P launched the S&P 500 in the 1950s. The 500 is now more widely followed by fund managers as a performance bogey. The number of indexes representing various sectors and themes in the market has also proliferated, though the Dow remains, alongside the S&P 500 and Nasdaq, the key barometer for the U.S. stock market.