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.
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.
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|Historical stock price data was taken from Yahoo finance. All calculations and charts are by https://badinvestmentsadvice.com/