If you read or listen to the popular media, you might get the impression that the Dow Jones Industrial Average, usually just the Dow, is the pulse of the market.
Other stock indexes like the S&P 500 or the Nasdaq Composite get play also, often in hushed or excited tones depending on numbers.
However, what do these and the other reported indexes really tell us and how should we use them?
What is an Index?First, let’s look at what an index number represents. Although there are different ways to calculate index numbers, it is important to remember the numbers represent a change from an original or base value.
The number is not important. What is important is the percent change over time. This movement up or down gives you and idea of how the index is performing. Is the Dow up or down? The index is calculated “on the fly” during trading to give investors a sense of direction to the market it represents.
Notice, I said the index reflects “the market it represents,” not “the market.”
Most stock indexes, even those quoted as representing the total market, only reflect a portion of the actual market.
Here are the most popular indexes and the markets they reflect.
The DowThe Dow Jones Industrial Average is the oldest and most widely known index. It is also the most widely quoted index and, mistakenly, considered the market barometer.
Originally, it was a simple average of the stocks in the index, but thanks to stock splits, spin offs and other transactions, more sophistication is now required. You can find more information at the Dow Jones Indexes site.
The Dow currently has only 30 stocks. However, each of these stocks represents one of the most influential companies in the U.S.
The Dow is the only major index that is price weighted, which means if a stock’s price changes by $1, it has the same effect on the index regardless of the percent change for the stock. In other words, a $1 change for a $30 stock has the same effect as a $1 change for a $60 stock.
The calculation of the Dow takes into account numerous stock splits over the years. By adjusting the math, it is possible to keep a historically viable index meaningful.
The Dow stocks represent about one quarter of the value of the total market, so in that sense it is a factor and big changes indicate investor confidence in stocks, however it does not represent small or mid-size companies at all.
S&P 500The S&P 500 is the most frequently used index by financial professionals as a representative of “the market.” It includes 500 of the most widely traded stocks and leans towards the larger companies.
It covers about 70% of the market’s total value, so in those terms it is much closer to representing the true market than the Dow.
The S&P 500 is a market capitalization or market cap weighted index, as are almost all of the major indexes.
Weighting by market cap gives more importance to larger companies, so changes in Microsoft stock will have a greater impact than almost any other stock in the index.
Even though the S&P 500 is weighted toward larger companies, it is a more accurate gauge of the broader market than the Dow is.
Even though some of the talking heads on TV may emphasize the Dow, you will get a clearer picture of the market by focusing your attention on the S&P 500.
The Nasdaq Stock Market CompositeThe Nasdaq Stock Market Composite is composed of all the stocks on the Nasdaq market – more than 5,000.
Although broad in coverage, the Nasdaq is heavily weighted to technology stocks. This is because it is a market cap weighted index and stocks like Microsoft and some of the other big technology companies influence the index.
Their influence and the population of small, speculative companies in the Nasdaq make the index more volatile than either the Dow or the S&P 500.
The Nasdaq obviously is not designed to represent “the market,” however it does give you a good idea of where technology investors are going.
Other IndexesThere are a number of other indexes that measure larger or smaller sections of the market. Mutual fund investors can find a number of funds that track almost any index they want.
However, the major three indexes above will serve most investors well. Should you want to look at other indexes for comparison, make sure you understand how the index is weighted (most, if not all will be market cap) and how stocks are selected.
What’s Good about IndexesIndexes provide useful information including:
- Even with their limitations, indexes show trends and changes in investing patterns.
- They give us snapshots, even if they are out of focus.
- Indexes provide a yardstick for comparison.