When you hear people say that the stock market is up or down, they’re actually referring to a stock market index, not the market itself. Since it’s difficult to measure the performance of the stock market as a whole, financial experts try to simplify things by using indexes as substitutes for the performance levels of the broader market. Nowadays, indexes aren’t only used as performance metrics, they also serve as a foundation for some of the most popular investment strategies. Below is a complete guide to understanding stock market indexes.
- What is a stock market index?
- What are the main stock market indexes?
- How to use a stock market index properly
- What is a stock market index fund?
What Is a Stock Market Index?
Basically, a stock market index refers to an index that provides a quick and easy way to measure the performance of the stock market or a certain portion of it. It usually takes into account a weighted average of share prices, meaning that larger companies will matter more in the calculation.
To understand how stock market indices work, let’s look at this example; you’re a high school student who wants to run for class president. The best way to know your chances of being elected is to ask your classmates individually if they’ll vote for you. However, this may require a lot of time and effort. Instead, you can just ask 10 students to get a general idea of how many will vote for you. Similarly, a stock market index gives you a quick glimpse of the performance of the stock market based on a sample of stocks.
In general, the relative change of a stock market index is more important than its actual numeric value. For instance, if the Financial Times Stock Exchange (FTSE) 100 Index is at 6,930.40, investors will know that it’s almost seven times its base value of 1,000. Nonetheless, you can only determine how the index has changed from one day to another by looking at how much it has increased or decreased, which is usually expressed as a percentage.
What Are the Main Stock Market Indexes?
There are thousands of indexes in the stock market. If you’re interested in using stock market indexes as part of your trading strategy, you only need to focus on three of them: Dow Jones Industrial Average, Standard & Poor’s (S&P) 500, and NASDAQ Composite.
Dow Jones Industrial Average
Also referred to as Dow Jones or Dow, the Dow Jones Industrial Average is one of the most widely used indexes in the United States. Created by Charles H. Dow and Edward Jones shortly after the Industrial Revolution, this index was initially comprised of a total of 12 stocks, many of which were the shares of industrial companies. Today, it’s made up of 30 of the largest publicly traded companies in the country including Walt Disney, Microsoft, Coca-Cola, McDonald’s, and Nike. Although it’s composed of only 30 companies, the Dow represents about 25% of the entire stock market in the United States.
The Dow Jones is a price-weighted index, meaning stocks with higher prices have a greater influence on its performance compared to lower-priced stocks. For example, suppose the Dow is composed of only three fictional stocks with prices of $10, $20, and $70. If the price of the $70 stock increases by 10%, then the Dow will increase by 7%. On the other hand, if the value of the $10 stock rises by 10%, the index will only go up by 1%.
Though the Dow Jones is the most widely used stock market index in the United States, it has two primary drawbacks. First, it only includes 30 stocks. There are thousands of stocks listed on the New York Stock Exchange and NASDAQ. With such a large number of companies trading, the Dow may not be a reliable indicator of the performance of the stock market as a whole.
Also, since the Dow is a price-weighted index, changes in higher-priced stocks will have more influence over its performance. For example, Boeing is trading at $344 per share, while Intel is priced at just $51.36. As such, a move in Boeing’s stock will have more than six times the impact of a similar change in Intel’s stock. Due to these drawbacks, many analysts consider the S&P 500 to be a better performance indicator of the stock market.
S&P 500 is a collection of the 500 biggest companies in the United States. Some of the most popular stocks that make up this index are Facebook, Amazon, AT&T, and Johnson & Johnson. Unlike the Dow, the S&P 500 is a capitalization index, which means that companies with larger market capitalization have a bigger influence on its performance than companies with smaller market capitalization. Market capitalization refers to the total market value of the outstanding shares of a company.
For example, Apple is currently the biggest component of the S&P 500. As of 2018, it’s estimated that the company’s market capitalization is equal to about 2.9% of the total index. This simply means that 2.9% of the performance of the S&P 500 is dependent on Apple’s shares.
For a company to be included in the S&P 500, it needs to meet the following criteria:
- Must be registered in the United States
- Must have a market capitalization of $5.3 billion or more
- Must have positive reported earnings in the last five consecutive quarters
- Must have outstanding shares that consist of at least 50% public float, which are shares that the public can freely buy and sell without any restrictions
- Must have stock that is traded in an active market at a reasonable price
The NASDAQ Composite is the market index that tracks the performance of 3,300 stocks in the NASDAQ Exchange. The NASDAQ Exchange and NASDAQ Composite are two different things. The former refers to the stock exchange that allows people to trade shares electronically, which eliminates the need for physical trading floors. In contrast, the NASDAQ Composite refers to the market index.
A large percentage of the stocks that make up the NASDAQ Composite belong to the technology sector. As of 2018, the technology sector accounts for 46.4% of the index, followed by the consumer services industry at 20.16%. Some of the most popular stocks in the NASDAQ Composite are Apple, Microsoft, Amazon, Facebook, and Google. This index is a market-value weighted index, meaning that its value is calculated by multiplying the last trading price of a particular stock with the number of outstanding shares.
How to Use a Stock Market Index Properly
Learning how to read a stock market index will help you make better trading decisions. When you’re analyzing changes in an index, you should keep the following in mind:
- The three top indexes don’t represent the total stock market in the United States. If the NASDAQ Composite is down today, it doesn’t necessarily mean that the prices of all the stocks in the index are down. Some stocks may be setting new highs on the same day.
- The indexes don’t move on emotion, but they react to actual trades.
- Avoid obsessing over the performance of the indexes. Focus on your stocks instead.
- The indexes aren’t meant for forecasting. Rather, they’re more useful for researching trends.
What Is a Stock Market Index Fund?
You can’t invest directly in a stock market index. However, you can put your money in an index fund, which is a type of mutual fund that tracks the performance of a specific index or other type of investment. For example, a Dow Jones index fund is an investment in all 30 stocks in the index, which duplicates its performance.
Index funds can help balance the risk in your investments, since market swings across an index are less volatile compared to individual stocks. As an index fund investor, you won’t be trying to beat the market or achieve higher earnings compared to market averages. Instead, you’ll attempt to beat the market by purchasing all the stocks that make up a particular index.
One of the biggest index funds in the world is the Vanguard Total Stock Market Index Fund. This fund gives you exposure to the entire stock market in the United States and includes small-cap, mid-cap, and large-cap value and growth stocks. Some of the features that make this index fund a great investment tool are its cost-effectiveness, tax-efficiency, diverse holdings, and low turnover.
Now that you know what a stock market index is, you can use it as part of your trading strategy. A stock market index plays a vital role in the analysis of the overall performance of the stock market. It provides invaluable insights into the state of the economy, risk inclination of investors, and trends for investment diversification. This can help you become a better-informed trader. If you want to know more about stock indexes or other aspects of stock trading, register for our free, 7-day RangingBull.com Bootcamp to learn from our accomplished trading experts.