The Dow Jones Industrial Average (DJIA), first compiled by Charles Dow in 1896, is the accepted benchmark of how well stocks perform each business day. Originally made up of 12 large industrial U.S. companies, the Dow has been expanded to include 30 top American companies that better reflect the country’s modern economy, covering a wide range of diverse industries. Staples of the current Dow include financial stalwarts like Citigroup, technology bellwether IBM, pharmaceutical giant Pfizer, media and entertainment mainstay Disney, and multinational conglomerate General Electric, the only original component still around today.

Though the Dow is the index most often cited by the media, it has been criticized, and even discounted, by some economists as skewed, since it is a price-weighted average, giving higher-priced stocks more influence than their lower-priced cousins. And, indeed, many market analysts say the Dow's broader counterparts—such as the Nasdaq composite, Standard & Poor's 500 and Russell indexes—provide a more accurate snapshot of the market as a whole. Despite the fact that it only reflects a portion of the actual market, most Wall Street insiders still consider the Dow a useful tool for measuring market trends when weighed with other major market indicators. 

Selecting Components 

Among money managers, a heated debate is raging about the process of formulating major U.S. indices. On one side of the isle are purists who maintain that the traditional system—weighting indexes based on their components' stock-market value—is the best method. The opposing, an increasingly popular, view argues that indexes should be weighted by component companies' fundamentals—taking into account cash flow, revenue, book value, dividends and other factors not directly linked to market capitalization. 

Most indexes use objective, rules-based methodologies to select companies for inclusion. The Dow is an exception. Its components are selected by The Wall Street Journal's editors, who don't use any predetermined criteria other than components being established companies that are leaders in their respective industries (though companies are subjected to rigorous analysis prior to final decisions being made). Changes in the Dow's composition are rare, generally occurring only after major mergers, acquisitions or other significant shifts in a company's core business. And even on occasions when components are replaced, the entire index makeup is reviewed, and sometimes simultaneously adjusted, for continuity and balance.  

Making Calculations 

Unlike the Dow, which is affected by changes in component stocks' prices, other indexes' weightings are influenced by both price fluctuations and changes in the number of outstanding shares. Generally, indexes are basic averages calculated by totaling their components' prices and dividing the sum by the divisor, which takes into account long-term corporate actions like stock splits and spin-offs. 

In the world of market-cap weighted indices, the portion of an index allocated to each component depends on the price of the company's stock multiplied by the number of outstanding shares. Supporters of equal weighting believe, on the other hand, that stock prices are not always accurate in determining a company's true value, since they can be distorted by speculation and momentum trading. Rather than ranking companies based on their market capitalization, these "fundamental indexers" advocate assigning a same-sized position to every stock, regardless of size.  

Most experts agree that calibrating indexes by fundamentals has a tendency to overweight overvalued securities and underweight undervalued issues. The argument is not without merit. For evidence, one only need look back to the late nineties, when many overvalued stocks' rising market caps pressured index funds to buy them as they grew to encompass more significant portions of major benchmarks. A poignant example is Cisco Systems, whose price-earnings ratio between 1997 and 1999 ballooned from 27 to a whopping 143, resulting in the stock accounting for 2.8% of the S&P 500, a 400% increase. By the dawn of the new millennium, 10 companies accounted for a staggering 23.1% of the index, while 50 stocks comprised 55.7%. 

Finally, while each index has inherent flaws, they all share one positive common trait: The fact that their aggregate value changes proportionally to the value of the stocks they contain. Over time, this provides a glimpse into trends and changes in investing patterns, making indexes essential tools for individual investors seeking to gauge the current performance and potential direction of the broader market.