+

Cookies on the Business Insider India website

Business Insider India has updated its Privacy and Cookie policy. We use cookies to ensure that we give you the better experience on our website. If you continue without changing your settings, we\'ll assume that you are happy to receive all cookies on the Business Insider India website. However, you can change your cookie setting at any time by clicking on our Cookie Policy at any time. You can also see our Privacy Policy.

Close
 

A guide to stock market indexes: What they measure and how they can guide your investing

Dec 24, 2020, 02:32 IST
Business Insider
A stock market index often acts as a stand-in for the overall financial markets, and even the economy.Tetra Images/Getty Images
  • Stock market indexes measure the performance of a grouping of individual, commonly themed stocks.
  • Stock market indexes act as benchmarks for individual assets or investment funds' performance — or even that of the stock market overall.
  • Individuals can invest in index funds that follow a particular index, or simply duplicate an index's holdings on their own.

In pop culture, the idea of a stock market index typically conjures images of the stock ticker in Times Square New York or traders screaming like they were extras in The Wolf of Wall Street.

Of course, in reality, it's much more than that.

Stock market indexes measure the performance of a grouping or "basket" of individual stocks. They're often used as a benchmark for mutual funds, investment trusts, and other vehicles that trade a portfolio of equities.

Advertisement

Beyond that, these indexes can be a key indicator of financial health and business trends, whether you're looking at a particular industry, the stock market overall - or even the entire economy.

According to the Index Industry Association, more than three million stock (and bond) market indexes exist in the world - 5,000 of them in the US alone. Some are well-known and often-quoted, like the S&P 500 and the Dow Jones Industrial Average. Others are more obscure, followed mainly by financial professionals.

Let's take a look at how stock market indexes are composed and how they can guide investors.

Advertisement

What is a stock market index?

At its heart, a stock market index is just a collection of individual stocks that fall within a certain category or share certain characteristics (or "theme," as the financial pros say). These groupings can be sprawling (like having a mix of large-cap, mid-cap, and small-cap stocks from a variety of sectors) or narrow (like having only stocks from a specific sector such as alternative energy or tech).

These bundles become like a bellwether, representing their industry or group overall. They help investors easily track a market or sector's economic health in the same way they would track an individual stock to determine the economic health of an individual company.

For example, the Nasdaq Composite Index is known for trading an abundance of technology stocks. In theory, one could look at the Nasdaq's performance and gain insight as to whether the technology sector is growing or shrinking - comparing its collective value in the past to its value today.

Advertisement

That's exactly what professional portfolio and investment managers do constantly. "Not only do indexes provide investors with a quick snapshot of the theme, says Joseph Hogue, CFA and founder of the Let's Talk Money! YouTube channel, "but they're also used by providers of mutual funds and exchange-traded funds (ETFs) to compare returns and performance in the theme."

How stock market indexes work

All indexes have a composite number, based on the value of their component stocks; with US indexes, it's expressed as a dollar figure. But it's not necessarily a simple total or average.

All indexes include bundles of stocks, but each individual stock's overall performance is weighted. Stocks with a higher weighting have more influence on how the index moves, and stocks with a lower weight are less influential. Typically, indexes are weighted one of three ways:

Advertisement

Market-capitalization-weighted indexes, like the S&P 500 index, give more weight to larger companies with higher market capitalizations (i.e. total dollar market value). "This is why giant, $2 trillion Apple is 6% of the S&P 500 index," Hogue says.

Price-weighted indexes give the most weight to stocks with the highest share price. For example, in the 30-stock Dow Jones Industrial Index, "shares of UnitedHealth Group with a price of $338 per share [are] weighted much more heavily than Cisco Systems whose stock price is just $44 per share," says Hogue.

Finally, equal-weighted indexes weigh each stock at the same level, regardless of how much each share costs.

Advertisement

What are the major stock market indexes?

There are thousands of stock market indexes in the United States, but the three most widely followed are the S&P 500, the Dow Jones Industrial Average, and the Nasdaq Composite Index.

  • Established in 1957, the S&P 500 was the first market-capitalization-weighted index in the US. It includes 500 of the nation's largest public companies and is worth about 80% of the US stock market's total value. Often, this index is seen as synonymous with the state of US stock markets, and of business overall.
  • The Dow Jones Industrial Average (DJIA) is one of the oldest stock market indexes in the US, dating back to 1896. It's also one of the smallest, including just 30 corporations. You may also hear them referred to as blue-chip companies. The DJIA is price-weighted, and like the S&P 500, it's often used to gauge the performance of the overall stock market and US economy.
  • The Nasdaq Composite Index is the relatively new kid on the block, established in 1971. Primarily focused on the technology sector - though it also includes some financial, industrial, insurance, and transportation stocks - it contains almost 3,000 companies. Stocks are market-capitalization-weighted, and all the companies in the index are traded on the Nasdaq stock exchange, but not all of them are based in the US.

Other popular US stock indexes include the Russell 2000, which is largely considered a reliable benchmark for the overall performance of small-cap businesses in the US, and the Nasdaq 100, which includes about 100 large-cap, non-financial companies traded on the Nasdaq exchange.

Here are the stats on six major US indexes, listed in order of their collective worth (market capitalization):

Advertisement
INDEXEXCHANGESNO. OF STOCKSSTOCK TYPECOLLECTIVE WORTH (Trillions)
S&P 500NYSE, Nasdaq, Cboe, BZX505Large-cap$30.5
Russell 1000NYSE, Nasdaq 1,000Large- & mid-cap$29.5
Nasdaq CompositeNasdaq2,667Large-, mid- & small-cap$9.8
Nasdaq 100Nasdaq103Large-capNon-financial$9.8
Dow Jones Industrial AverageNYSE, Nasdaq30Large-capBlue-chip$8.33
Russell 2000NYSE, Nasdaq, OTC Mkts Grp1,995Small-cap$1.9

Source: Financial Express

Outside of the US, some of the most popular indexes include the MSCI World Index, the FTSE All-World Index, and the S&P Global 100 Index.

How to invest in stock market indexes

You can't explicitly invest in an index, but you can invest in either individual stocks or a mutual fund or exchange-traded fund (ETF) that includes a portfolio of stocks from a specific index. The latter is a passive investing strategy: Often, this index fund simply mimics its benchmark index, automatically adjusting its holdings as the index changes.

Advertisement

"Investing in an index, or an ETF that tracks an index can offer an easy strategy to get your whole portfolio in just one or a few funds," says Hogue. "Since the index includes hundreds or even thousands of stocks, you're getting all the diversification you need and your portfolio won't crash with the fall of just one stock."

Investing in individual stocks within an index is a more active strategy that comes with greater control and fewer fees. You can hand-pick the stocks and choose when to buy or sell them.

Typically, you'll need between 20 to 100 different stocks to achieve enough diversification, which is hard at the start because it takes a greater amount of money. But you have fewer fees - since you're avoiding the fund's ongoing expense ratios - and greater control.

Advertisement

The financial takeaway

Stock market indexes provide a key way to measure the financial strength and performance of various equities, industries, and other market segments. The returns of individual assets, asset classes, and investment funds are often judged against that of an appropriate index.

The larger, more established indexes, such as the S&P 500, act as are stand-ins for the entire stock market. Their movements up or down can offer an economic outlook for a country or even the world.

And, on a smaller scale, a stock market index can be an individual's guide to choosing investments. As long as you remember: at the end of the day, it's just an indicator.

Advertisement

Related Coverage in Investing:

What is common stock? The most typical way to invest in a company and profit from its growth

What is the P/E ratio? An analytical tool that helps you decide if a stock is a good buy at its current price

The price-to-book ratio is a way to determine if a company's stock price accurately reflects its financial value

What is a stock split, and is it a good or bad sign when it happens?

8 of the biggest stock market crashes in history - and how they changed our financial lives

Next Article