Transcripts

How Wall Street Works - The Dow and Other Indices

PAUL KANGAS: Because stocks often move together, it can be helpful to know the general direction of prices on Wall Street. That's why every few minutes, investors ask: how's the market doing? And the answer boils down to one number: the Dow Jones Industrial Average or the Dow for short. Actually, the Dow is an index of the prices of 30 component stocks. As we can see here, it currently includes some of the biggest names in corporate America and it has a long history. I talked about that with David Leonhardt of the "New York Times." First, just how did the Dow Jones Industrial Average get started and what makes it such a key market barometer?

DAVID LEONHARDT, COLUMNIST, NY TIMES: Well, it started in 1896 when Charles Dow sat down with a piece of paper and a pencil and tried to make sense of the stock market. Until then it was really hard for investors to know what was going on; they would see some stocks up, some down. And what he did was he calculated an average and it was incredibly important and it remains incredibly important. The main reason it remains so important, though, is that it has been followed for so long. If you're looking for an accurate gauge of the stock market, the Dow Jones Industrial Average is not the best place to go today.

KANGAS: Now here is the list of the original 30 components of the Dow way back in 1896. And it's interesting to note that only one of the originals-- General Electric -- is still in the average. Who decides what's stocks get in the Dow and how often are its component stocks changing, David?

LEONHARDT: Well, editors at Dow Jones decide what goes in there and the fact that General Electric is... as you can see from that list, it changes with regularity. And the fact that General Electric is the only company left just tells you about the amount of creative disruption that there is in the American economy. The most important companies today were nothing like the most important companies 30, 50 and certainly 110 years ago and that tells you, in some ways, about the dislocation and also about the dynamism of the economy.

KANGAS: Interesting. Now besides the Dow Jones Industrial Average, there's another broad market index, namely the Standard & Poor's 500. What can you tell us about the S&P 500 and do you think it's a better measure of market activity than the Dow?

LEONHARDT: I do think it's a better measure. I think it's a significantly better measure than the Dow for two reasons. One, as you noted, it's much, much broader. It covers 500 large cap companies rather than just 30, which is what the Dow Jones covers. For a second thing, there is a funny way that the Dow Jones Industrial Average is calculated. And it's calculated that way because, as I said, Charles Dow started this in 1896 with pencil and paper and it's not so easy to create a weighted average with pencil and paper. And so, for technical reasons, in the Dow Jones, a company like Caterpillar is actually more important than General Electric of Citigroup or Microsoft. Obviously in the broader economy, Caterpillar is not more important than General Electric or Microsoft or Citigroup. And the S&P is weighted toward the size of companies. Now, the S&P has some of its own flaws, but as a broad market measure, it really is significantly better than the Dow today. As a historical measure going back to 1896, you can't do better than the Dow Jones Industrial Average.