What is a Stock Market Index?
Have you ever wondered what all of those numbers on the nightly business report actually mean? Michael Fischer explains:
Just as you cannot accurately gauge the health of a garden from the growth of a single plant, you cannot gauge the health of the market from the performance of s single stock. Stock market indexes — or indices, if you prefer — allows us to track groups of stocks instead of simply following individual stocks.
Dow Jones Industrial Average (DJIA)
On 26 May 1896, Charles H. Dow introduced his method of gauging market health, which was simply to take the average price of twelve specific stocks. Now, more than one hundred years later, the DJIA is a little more complex. According to the official website, since 1928 the index has comprised 30 blue chip stocks, as selected by the editors of The Wall Street Journal. The average share price of these stocks is divided by a special number meant to reduce “distortions” from non-essential factors. The Investopedia has more on how the Dow Jones Industrial Average is calculated.
Standard & Poor’s 500 Index (S&P 500)
The 500 companies that make up the S&P 500 are meant to reflect the largest American corporations. The index was introduced on 04 March 1957, and was one of the first (the first?) computerized stock index. The companies in the S&P 500 are selected by a committee, and then each stock is weighted according to the company’s market value. Though the DJIA is more well-known, the S&P 500 is a more accurate representation of actual market performance.
Other Indexes
There are tons of stock market indexes, not just in the United States, but around the world. The wikipedia entry on the subject lists many of them. Some of the more well-known include:
- London’s FTSE 100
- France’s CAC 40
- Germany’s DAX 30
- Japan’s Nikkei 225
- The MCSI EAFA, which is an index of non-North American stocks
- The Wilshire 5000 is meant to measure the entire U.S. stock market.
There are also smaller indexes meant to represent sections of the market, such as utilities, or transportation, or technology.
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There are 3 comments to "What is a Stock Market Index?".
The Dow
The grand-daddy of them all. If you ask an investor how “the market” is doing, they’ll probably tell you about “the Dow”. This index is formally called the Dow Jones Industrial Average (DJIA) and it is the most well-known and most frequently used index in the world. This index is comprised of 30 of the world’s largest and most influential companies. The 30 stocks that make up “the Dow” change periodically, and if you were to take the stock price of all 30 current stocks, and add them up, you would not wind up with the 12,500 point index we currently have. Why? The DJIA is a price weighted index. Originally it was computed by adding up the per-share price of the stocks of each company in the index and dividing this sum by the number of companies – that’s why it’s called an average. Over the years, however, stock splits, spin-offs and other events changed the divisor, making it a very small number (less than 0.2).
The DJIA represents about a quarter of the value of the entire U.S. stock market, but a percent change in the Dow should not be interpreted as a definite indication that the entire market has dropped by the same percent. This is because of the Dow’s price weighted function. The basic problem is that a $1 change in the price of a $120 stock in the index will have the same effect on the DJIA as a $1 change in the price of a $20 stock, even though one stock may have changed by 0.8% and the other by 5%.
A change in the Dow has a huge impact on the average investor’s concept of the economy, the overall stock market, and even the world economy, although it is a mathematically-flawed index.
What other index could you use?
The S&P 500
When investors say that their portfolio has “beaten the market”, they are usually referring to the performance of this index. The Standard & Poor’s 500 Stock Index is a larger and more diverse index than the DJIA. It is made up of 500 of the most widely-traded stocks in the U.S., and represents about 70% of the total value of U.S.stock markets. This is why this index gives investors a better benchmark for average stock performance and a clearer indication of the movement of the U.S. marketplace. Yes, there is much overlap in the stocks used for the various indexes.
The S&P 500 Index is also a market weighted index, meaning that every stock in the index is represented in proportion to its total market capitalization. A 10% movement in all stocks in the DJIA would not necessarily cause a 10% change in the index, but the S & P 500 Index would. Another characteristic of the S&P 500 Index that makes a solid benchmark is the fact that it includes companies in a variety of sectors, including energy, industrials, information technology, health care, financials and consumer staples.
The Wilshire 5000
This index is known as the “total stock market index” or “total market index” for one simple reason. The Wilshire 5000 Index includes more than 7,000 of the 10,000-plus securities that are publicly traded in the United States. Don’t let the ‘5000’ fool you. This index includes all publicly-traded companies (with headquarters in the U.S.) that have readily available price data. Because the index was finalized in 1974, and is therefore relatively new to Wall Street, it is less often referred to than the less comprehensive S&P 500, although it’s a near-perfect measure of the entire U.S. market.
The Nasdaq Composite Index
Most investors know Nasdaq as the home of Microsoft and the exchange on which technology stocks are traded. The Nasdaq Composite Index therefore is used when discussing tech stocks. The index itself is a market value weighted index of all stocks traded on the Nasdaq stock market, which includes more than 5,000 companies. Some of these, unlike the Wilshire 5000, are not based in the United States. Many people overlook the fact that aside from tech stocks, the index includes stocks from financial, industrial, insurance and transportation industries. The Nasdaq Composite includes large and small firms but, unlike the Dow and the S&P 500, it also includes many speculative companies with small market capitalizations. Consequently, its movement generally indicates the performance of the technology industry as well as investors’ attitudes toward more speculative stocks.
The Russell 2000
The Russell 2000 is a market value weighted index of the 2,000 smallest stocks in the Russell 3000. The Russell 3000 is an index of the 3,000 largest publicly-traded companies, based on market cap, in the U.S. stock market. What makes The Russell 2000 index popular is that during the 1990s, small-cap stocks soared and investors moved more money to this sector. Today most investors view the Russell 2000 as the best indicator of the small company performance in the market, and the index is very general, meaning it is not dominated by a single industry as some of the other indexes are.
There is no explicit international representation here Of course large Large US companies have international exposure, but I count that as secondary exposure.
I suggest the EAFE Stock Index. Its tracked by Morgan Stanley Capital International, Inc. (MSCI), and is used as the “default” indexed international fund for Vanguard —
Vanguard Developed Markets Index Fund (VDMIX). The United States Government also provides this index fund as part of its retirement options. Fidelity has a similar tracking fund: FSIIX.
Buy a diversified portfolio of stocks versus an index. It’s a lot more fun and if you do your homework, you’ll beat the S&P index.