What is an index in the stock market? We’ve all heard newscasters report the stock market activity with a few words, like –
” The markets were strong today, the DOW closed one hundred points up, the Nasdaq Composite was up 50 and the S and P gained 25.”
And if we have a 401k or an IRA we are supposed to get a good dose of warm fuzzy that all is good with our retirement funds and we can sleep well tonight. So what are the Dow Jones Industrial Average, the Nasdaq Composite, and the Standard and Poor’s 500? They are all stock market indexes.
Definition
A stock market index is a number calculated from the prices of exchange-listed stocks. Stock market indexes are a shorthand way of looking at how a market is performing at any one time.
The main stock market indexes
The main stock market indexes that capture headlines news in the US and around the world are:
The Dow Jones Industrial Average – this is calculated from the 30 largest blue-chip industrial company shares listed on US stock exchanges.
The S and P 500 – this is the most used abbreviation for the Standard and Poor’s 500 index. The S and P 500 tracks the prices of 500 large companies listed on US stock exchanges.
The NASDAQ Composite – this is calculated from all the companies listed on the NASDAQ which stands for the National Association of Securities Dealers Automated Quotations.
Occasionally you will hear mention of the Russel 3000 and the Russel 2000 but there are thousands of other stock market indexes the vast majority of which are only of interest to specialists or investors interested in specific industry sectors, companies of similar size of particular kinds of stocks.
What are stock market indexes for?
Stock market indexes are intended to give all investors and financial professionals a quick way of knowing how a stock market is doing.
Today there are more than five thousand stocks listed on the New York Stock Exchange. There are more than two thousand listed on the Nasdaq and there are other US exchanges and international exchanges where you can buy and sell stocks.
Each stock market index was started with a particular purpose in mind. There are indexes that track the stocks of specific industry sectors such as telecoms, healthcare, or energy. Other indexes track mid-cap stocks or small-cap stocks and yet other indexes track growth stocks, developing markets or emerging markets.
Today, nearly all of these indexes will have Exchange Traded Funds or ETFs that track their movements. Some of the indexes that have been around for a long time have different funds at different price levels that track the underlying index.
The Dow Jones Industrial Average
The Dow Jones Industrial Average or DJIA for short is the second oldest index in use today. It was launched in 1886 and was preceded by the Dow Jones Transportation Average which was launched in 1885 when railroads and steamships were all the rage and the growth of transportation was largely responsible for growth in international trade and the world economy.
One of the advantages of the DJIA is its simplicity. It started as just the numerical sum of the stock prices of the 30 stocks that make up the index. The 30 stocks chosen were the 30 largest industrial companies listed on the exchange at the time. The composition of the DJIA has changed as companies’ fortunes waxed and waned. Since its inception, the DJIA has been composed of the 30 major industrial companies listed on US stock exchanges and that is still the case today.
The calculation of the DJIA started life as a simple numerical sum of the stock prices of the 30 constituent companies. But then what happens as companies grow is they undergo stock splits. Let’s say you own 100 shares of XYZ company and the market price is $100 a share. That is actually an impediment to small investors as they can only invest and trade in the shares of the company in multiples of $100.
What companies do to deal with this is they split their shares. In a simple example of a 10 for 1 split, if one day before the split you owned 100 shares of XYZ company and the market closed at $100 per share, after a 10 for 1 split you would wake up the next day owning 1,000 shares of XYZ company at a market value of $10 per share.
Simple stuff indeed. But what if XYZ company is one of the 30 constituents of the DJIA. If no adjustment is made then every time there is a stock split in one of the constituent companies the index would drop. To avoid this the sum of the 30 constituent share prices is divided by a number that is adjusted each time such an event takes place.
The Dow Jones Industrial Average Calculation
In April 2020 the divider of the DJIA was 0.1458. This means that the DJIA is actually 6,859 times more than the numerical sum of the 30 constituent share prices. Just to be clear 1/0.1458 is 6,859. Here are the 30 constituent companies of the DJIA and a calculation of the index on 30 April 2020.
1)Historical stock price data was taken from Yahoo finance. All calculations and charts are by https://badinvestmentsadvice.com/
The Dow Jones Industrial Average is still a headline index for US stocks but it is not as useful numerically as other indexes like the Standard and Poor’s 500 index. The DJIA only records the sum of the prices of those 30 large blue-chip stocks.
The DJIA has two fundamental weaknesses. Firstly, it doesn’t factor the market capitalizations of those 30 companies and secondly, the share prices of 30 large companies is a very unrepresentative proxy for the performance of the many thousands of shares on US stock exchanges.
For the above reasons, because the Dow Jones Industrial Average principally has a headline and psychological impact, to understand what is happening with the broader stock market, most investors pay more attention to the Standard and Poor’s 500 index.
The Standard and Poor’s 500 Index
The S and P 500 index is generally accepted to represent the broad market of US stocks. It tracks the performance of 500 large companies listed on US exchanges. The index is weighted by the market capitalizations of the 500 companies. Currently, the 10 largest companies in the index account for 27 percent of the total.
The S and P 500 is still an index of large companies. So from that perspective, it does not give any indication of what mid-cap and particularly small-cap stocks are up to.
The NASDAQ Composite
The NASDAQ Composite tracks the performance of the more than 2,500 companies listed on the NASDAQ exchange. The contributions of each company is weighted by market capitalization. A divider is also used, like for the DJIA to adjust for stock splits.
The Russell 3000 and the Russell 2000
The Russell 3000 is an index that tracks the performance of 3000 US-listed stocks. The Russell.2000 tracks the performance of the 2000 small-cap component companies of the Russell 3000. For this reason, the Russell 2000 is often looked at and quoted as reflecting how small-cap US stocks are performing.
How the stock market indexes are used
As explained above, the market indexes are used to get a sense of the performance of different parts of the market, or the broad market. Different investing and trading strategies use the indexes differently. Some investors just hold funds that track one or more index.
To see how a fund that tracks the S and P 500 would have performed over any 30 year period between 1957 and 2019 check here.
Other strategies pay attention to the indexes to get a sense of whether the market is bullish or bearish or undecided.
To read up on some history of the Dow Jones Industrial Average, check here.
This is a single-page PDF summary explaining stock market indexes.
I hope you found this article interesting and useful. Do leave me a comment, a question, an opinion or a suggestion and I will reply soonest. And if you are inclined to do me a favor, scroll down a bit and click on one of the social media buttons and share it with your friends. They may just thank you for it.
Disclaimer: I am not a financial professional. All the information on this website and in this article is for information purposes only and should not be taken as investment advice, good or bad.
Affiliate Disclosure: This article contains affiliate links. If you click on a link and buy something, I may receive a commission. You will pay no more so please go ahead and feel free to make a purchase. Thank you!
References
| ↑1 | Historical stock price data was taken from Yahoo finance. All calculations and charts are by https://badinvestmentsadvice.com/ |
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Great article on What is an index in the stock market? I’m new to learning about the stock market so thank you for helping me with a clear explanation. Best wishes for success.
Hi and thanks for your comment. I am glad you found it interesting. Best regards, Andy
Wow, this post is mind-opening. I honestly used to think Dow Jones is a single company the same way I did about S and P 500 and NASDAQ. Now I have learnt about more than just index. Your site is the ultimate starter pack when it comes to trading. Thank you for sharing.
Hi and thanks for the comment. I am glad you like the article and the site. Best regards, Andy
Thank you Andy,
I am new to the stock market, but reading your post about what is an index in the stock market? Made me understand everything, it is very interesting how the market indexes work.
Hi Nataliya
I am glad that you found it so interesting. Thanks for the comment, Best regards, Andy
When it comes to investing in stock, now for me personally I would never do it. it sounds too risky! I guess there’s nothing wrong with folks investing in the stock market. I guess I never would invest because I don’t know that much about it. (Hell, I’d lose my shirt). Some smart people know when to buy when things are looking good and sell, when not so good. Some knowledge in the stock market must be in the person investing. How much money would you know to invest? And what to invest in? I’ll just have to pass when it comes to the stock market. This is just my own opinion.
Hi and thanks for your comment. Your sentiments may seem to you as if you are giving up on investing in stocks before even starting. However, this is very revealing of where many people are in saving for their futures. And actually it is very useful for me to receive these kinds of comments. You are absolutely right that there are many risks involved in investing in the stock market. If you are unlucky enough to start investing just before the market has a major reversal, then you are likely to get very disheartened if seeing your investment lose value just a matter of weeks or months after you start. It is of great importance to know yourself as an investor or saver and know your risk tolerance so you can make good investment decisions for yourself. There is something else you should be aware of though. That interest rates are currently so low they are not keeping pace with inflation. This means if you have money in savings accounts or fixed interest accounts the chances are that the real value of your savings steadily diminishing over time. If you have a few more minutes to spare, I would sincerely suggest that you check these few articles as well.
https://badinvestmentsadvice.com/how-to-begin-investing-in-stocks-steps-to-take-before-you-invest/
https://badinvestmentsadvice.com/stock-market-returns-for-the-last-30-years-when-to-invest/
I would be very pleased to hear how you found these. And please let me know if you have any questions, concerns, or suggestions. Please don’t misunderstand me, I agree that today would be a very risky time to be entering the market for the first time. There are many signs that the markets could take a tumble as we know the world economies are going to be in recession probably for a few years because of COVID. We should all be treading with caution, but IMHO we should also be moving forward because standing still is likely to mean falling behind.
Best regards
Andy
Hi Andy. Thank you for sharing this informative article. I have invested in the stock market before in the past but I didn’t really study it deeply. I have seen the stock market index but didn’t know what it is, therefore didn’t really make use of the information. After I read your article it has helped me to have a better understanding of the stock market indexes. Thank you!
Hi Janet. Thanks for your comment. I am glad you found the article informative. Best regards, Andy
Hello. Great and very informative article. You explained everything in great detail. Any reader would leave here knowing exactly what a index on the stock market is and how it works.
Thank you
Hi and thanks for your comment. It is indeed interesting just how many people who invest have a partial understanding of how the indexes they may even be using every day actually work. Thanks again and best regards, Andy
Hi Andy,
Thank you for your article – It is very informative. You made us understand a lot of different stock market indexes, and how and where each index originated from. Investing in stocks has always been one our favourites tools, we have built a diversified portfolio to minimize our risk and achieve more profit for the future, it is interesting, but rather scary – if you know what we mean, especially during March 2020, when almost all of the stocks in our portfolio were losing value… well…, we understand what we sign up for, right…
Thank you once again, wishing you all the best…
Kalle & Marie
Hi Kalle & Marie and thanks for your comment. Yes, the markets in March this year were indeed very scary. I have to say I don’t think we are out of the woods yet and I would not be surprised if we see similar volatility at least through the end of this year and likely well into 2021. Good luck and thanks again for your comment. Best regards, Andy
Before I stumbled across your article I thought I knew a lot about indexes – oh wow I learned so much – great article Andy. We know that the indexes show the performance of the market – but I think a lot of people tie the index levels to how the economy itself is doing – what are your thoughts on this?
Hi Trevor and thanks for the comment. The general observation is that stock market cycles lead economic cycles. The stock market tends to boom ahead of economic expansion and on the other side, a stock market collapse tends to foretell an economic recession. But there is a definite lag since supply chains and employment dynamics take time to manifest. There is another article on this you may want to check out. It also explains the psychological and emotional side.
https://badinvestmentsadvice.com/stock-market-cycle-indicator/
Let me know if you have any thoughts, comments, or questions on this I would be pleased to answer. Best regards, Andy
Hi Andy,
Stock markets have always confused me with all the financially technical-sounding codeword type terminologies. That is one of the most important reasons I haven’t yet started investing in stock markets. Sometimes I do feel I should go for some stock market basics course if I can get my hands on one.
However, you have done a great job through this article and I am now comfortable understanding about indexes n stock markets.
I am happy that I stumbled upon your website and that it will be of great help for me to learn about stock markets.
Thanks a lot
Hi Nick and thanks for your kind comments. I am glad you found it informative and free of unnecessary terminology and jargon. Please do check out other articles on this site and don’t hesitate to leave any other comment, ask a question, or even suggest any topics you would like to see covered. I would be pleased to respond or even add articles as appropriate. Thanks again with kind regards, Andy
Hi Andy, thank you for your very informative article. I found it very interesting to go deeper to the stock market, as I made some investments in there. Untill now it was all about, that I had a man who was doing it for me, but I would also be happy to do it by myself. You brought here some clarity( differences between the metrics, various indexes). I think that for the right understanding, one has to learn and study a lot. I’d like to ask you, how ling did it take for you to get that knowledge? And are you professional in this field?
Hi Julius and thanks for the comment. I am glad you found the article informative. My personal story in this respect is that I started in my early 20s when I responded to an ad in a national newspaper and opened a managed futures account. That was an educational experience. Then in my early 30s, I started investing in stocks on advice from a broker working in my bank branch. That was basically a – chasing hot story – approach. I made various other forays. Then around 20 years ago I read What Works on Wall Street and worked out how I could adapt the approach to my own circumstances. I used a stock screener to basically sort for liquidity by eliminating any market cap stock under around $150M, then an indicator of potential to appreciate in price, that was mostly price to sales below 1, and then momentum and that was greatest price appreciation over last 12 months. Basically I would sell whatever I had bought 13 months ago and bought the highest-rated stocks coming through the screener. That worked well for a number of years and beat the S&P by a few percents or more each year. Then the screener I was using was no longer available so I had to change approach. Instead of best price appreciation over 12 months, I settled for the highest percentage of the last 52 weeks high. Over time this stopped working as well. I introduced other refinements also suggested by later editions of the same book, namely to better screen for price momentum using appreciation over the last 3 and last 6 months. There are weaknesses in this approach that have been written about. Now I am focussed on momentum and sector strength. I am not a financial professional. As regards this site, as per about me, I realized that over the years I have heard all manner of investment advice which may sound good but turns out to be bad. So that is one of the hooks of this site – sharing what I have learned. Thanks for your question. Best regards, Andy
I was wanting to invest in the cruise industry since the Covid-19 started as I feel it has a great earning potential since the cruise industry will never be completely stopped. Here I am, patiently waiting to go back to work :), and in the meantime, I am thinking of their stocks. I feel so bad that I haven’t got them 7 years ago when I started working for the cruise line. Unfortunately, I couldn’t find a way to do it from Serbia.
Finally, would you please advise me which share would be the best for the newbie? Some friends of mine hurried to buy some and they are very happy with a choice.
Which trade address you would recommend?
Thanks
Hi Sunny and thanks for the comment. I must admit I would be especially cautious of the cruise industry as they have been hit hard by the COVID situation and they are likely to experience difficulties for a while. The share prices of the three major lines that account for three-quarters of the industry have all dropped by about ten percent. I don’t see them bouncing back any time soon. Related to this I have actually recently taken a bearish position with regard to the leisure industry. Over the next 3 to 6 months I think leisure, entertainment, and that whole sector will continue to have a hard time in the US certainly.
I am not sure what you would be able to invest in living in Serbia. As regards what areas to invest in at present I would look to the strongest sectors leading the market advance. That is currently the technology sector. If you can buy into a fund or an ETF that invests in the technology sector that would be a good choice. You should know that the broad market is looking over-bought so a correction is likely. So you will always likely see a reversal whatever you may buy in the short-term. But I think the technology sector is likely to stay strong for at least another year or two. I would be reluctant to be more specific than that.
I hope this helps and thanks again for the comment, with best regards, Andy
The stock market has always been a thing that usually baffles me because I do not know how it actually works but it seems like you have done your research really well and you know your way around everything about it which makes it even easier for me as well. Now I see that the market index is a way to calculate the way the market is going. This is one term that I understand now!
Hi and thanks for your comment. I am glad you found it informative. Best regards, Andy
Hmm, I had been wrong for some time about market Indexes. My worst mistake was misinterpreting what Indexes were for. I’m kinda newbie to the stock market but I have been dedicating a lot of time to this in recent months. I liked your post and I’ll follow your site for more updates. Thank you very much!
Hi and thanks for your comment. I am glad you found that article informative and that it helped clear something up. Please do check the other articles and let me know if you have any issues, questions, or suggestions and I would be pleased to respond. Best regards, Andy
Thank you so much for sharing a beautiful and insightful article with us. The prime element of this article is about indexes in the stock market. It is impressive that you covered this subject so well in your post. I’ve learned a lot from reading your article and added a great deal to my knowledge of the subject. I liked the Dow Jones Industrial Average calculation as you explained in your article.
I would like to share your article with my friends on Facebook..
Thanks for your comment and positive feedback. I am very glad you found it informative. Best regards, Andy
Though I have actually seen a lot of people switch over from stocks to focus more on trading the indexes because they are much easier to trade than individual stocks. However, for myself, I am a currency a trader of forex. I feel the indexes play a role in indicating the volatility and have an effect on the forex market. What is your opinion on this observation? Thank you.
Hi Sherry and thank you for your comment and question. The markets are indeed linked as they are all linked in some way to the underlying economy. Having said that, forex trading is on such a scale these days, the stats are actually mind-boggling. Remembering that forex markets were originally created to facilitate international trade but the turnover on nearly all forex markets is many many times the underlying value of the trade. It would seem that the vast majority of forex trading volume is driven by speculation rather than any underlying need of companies to acquire currency to be able to buy or sell goods and services across national boundaries and between currency zones. I would therefore not expect to see much causal link between stock market activity and forex market activity except at times of extreme market duress for example when everyone is rushing into cash. In other words, if there was a plunge in the stock market illustrated by a substantial drop in the main indexes I would not be surprised if that coincided with more than usual volatility on the forex markets. As Warren Buffet famously said – it is when the tide goes out that you will see who has been skinny dipping. Thanks for the question and best regards, Andy
Great article about the term “index” in the stock market. This is an eye opening post. Though I am new to the stock market, your post about what is an index is in the stock market made me understand everything. It has helped me to have a better understanding of the stock market indexes. Thank you!
Hi Rajesh and thank you for your comment. I am glad you found the article helpful. Best regards, Andy
I thought I had a really good grasp on the stock market but you definitely opened my eyes to exactly how the Dow Jones Industrial Average is really calculated. Thank you for an explanation that even I can understand. I am intrigued by the Russell 3000 and the Russell 2000 indexes and will definitely need to do further research. Which indexes do you recommend to watch to look for downturns or upturns in the overall market?
Hi and thanks for your comment and question. I would summarize as follows, the Dow is a headline figure and really intrinsically significant when it breaks through distinct numerical values either in an upward or in a downward direction. I mean if the Dow goes through 30,000 that will be an event. For the broader market, most people are watching the S&P 500. Though the S&P 500 is itself still dominated by the top 10 stocks which make up I think about 27% of the index just because of their market cap. If you want to get a better view of what mid and small-cap stocks are doing then the Russel 2000 is a good one to watch. But for the major turns, i.e. determining whether the market as a whole is bullish or bearish, I watch the S&P 500. Thanks for the great question. Best regards, Andy
Excellent article here! As an investor, I can attest to how well you have done laying out something as basic as indexes for the common folk. In today’s environment, with so few true fiduciaries available, finding easy to understand, honest information that can benefit the masses is tough to find. Well done.
Hi and thanks for the positive comment. The more I discuss this subject and interact with people on this the more I realize that indeed what you say is true. So much of the information that is widely available today on investing is not very user-friendly that the obstacles to first-time investors are actually quite high. Thanks again and I appreciate your comment. Best regards, Andy
Thank you very much for this beautiful article. This is really great & helpful. I read it & learn about many things from here. This type of idea improves trading for betterment.
Hi and thanks for stopping by. I am very glad that you found the article interesting and I hope useful. I wish you the best of luck with your investments and trading. Best regards, Andy