by Shelley Seagler
You’ve probably heard talk on the news about how the market was up or down. When people discuss “the market,” they are actually referring to a market index. A market index measures a specific section of the stock market and helps investors evaluate how well the market, or at least a particular section of the market, is doing. Although there are a number of indices, the three that are most commonly referred to and quoted are the Dow Jones Industrial Average, the Standard & Poor’s 500, and the NASDAQ Composite Index.
The most widely known index in the United States is the Dow Jones Industrial Average. The Dow was created to provide a clear, straightforward view of the stock market and, by extension, the U.S. economy. When Charles Dow first published the Dow in May of 1896, it included 12 stocks from leading American companies. Today, it represents the stocks of 30 of the largest and most influential companies in the United States. Of the original 12, only General Electric is still on the list.
Originally, the Dow was simply an average of the stocks it included. But it now uses a more sophisticated approach. The Dow uses a price-weighted system that involves adjustments for things like stock splits and spin offs to ensure the index continues to be a meaningful measure of the market. Although the scope of the Dow is limited to 30 stocks, it still represents about one quarter of the value of the total market.
In addition the Dow Jones Industrial Average, the S&P 500 is one of the most commonly followed market indices. Because the S&P 500 covers 75% of U.S. equities, it is typically considered a better measure of the market than the Dow and is the most commonly used benchmark for the stock market. It is owned and maintained by Standard & Poor’s and represents 500 leading companies in leading industries of the U.S. economy, including both growth and value stocks.
Unlike the Dow, which is price-weighted, the S&P 500 is a market capitalization weighted index, which means more importance is given to larger companies. And since it was first published in 1957, it has been widely considered the best single gauge of the large cap U.S. equities market. As with most indices, there are funds that attempt to track and replicate the performance of the S&P 500 by holding the same stocks as the index, in the same proportions.
You may have familiarity with the NASDAQ stock exchange. In addition to the exchange, there is also the NASDAQ Composite Index. The NASDAQ Composite Index is made up of the more than the 3,000 common equities traded on the NASDAQ stock exchange. Although the NASDAQ is broad in coverage, because it is a market-cap weighted index, it is heavily weighted to technology stocks. This is because stocks like Apple, Microsoft, and other big technology companies significantly influence the index. The NASDAQ is considered to be the leading indicator of technology and growth stocks.
Because the Dow, the S&P 500, and the NASDAQ Composite Index are all designed to track the market and give an indication of how it is performing, they typically move in step with each other. And when one index moves up or down, the others follow suit. But because each index tracks a different set of stocks, the degree to which they move may not be the same. For example, the Dow, which tracks the stocks of the country’s biggest companies, does not usually move up or down as much as the other indexes. And the NASDAQ, which also includes a number of small, speculative companies, tends to be more volatile than either the Dow or the S&P 500. Additionally, because the NASDAQ is the leading gauge of technology stocks, it is certainly possible that from time-to-time, it can move entirely out of step with the rest of the market.
In addition to the major three indexes, there are several other indexes that measure larger or smaller sections of the market. Investors can find a number of funds that track almost any of the indexes. To make an accurate comparison between any of the indexes, you must know how it is weighted (most, if not all, will be market cap), as well as which section of the market it is tracking.
Market indexes provide a snapshot of how the market is doing – but keep in mind, the snapshot may, from time-to-time, be a little out of focus. However, even with their inherent limitations, indexes still offer meaningful information and provide a useful yardstick for comparison. This is especially true when we look at an index from a historical viewpoint. One last note about market indices, although you should understand what they are and what their significance is, if you are a long-term investor, you shouldn’t be overly concerned by day-to-day fluctuations.