Understanding Stock Market Indices
When watching the news on television or listening on the radio, there are often reports about the daily performance of the stock market. Usually the announcer is referring to either the Dow Jones Industrial Average or the S&P 500, and sometimes you might hear about the NASDAQ. These are just three of the many stock market indexes, or indices, that are active in the United States. There are also many stock market indexes in countries around the globe.
What Is a Stock Market Index?
A stock market index represents a particular segment of the stock market and measures, as an average, the performance of all the companies included in that index.
Some indexes measure the performance of large companies known as large caps. Large caps are companies with large capitalization, meaning these companies have large financial resources. Some indexes measure the performance of mid-caps, and small caps. There are also indexes that measure market sectors, such as transportation stocks, utility stocks, and commodity stocks, to name a few. In fact, there are dozens of indexes, all designed to help investors understand whether an investment in a particular area of the stock market has the potential for making a profit.
How Is a Stock Market Index Composed?
The purpose of an index is to identify the trend of a market sector so that investors can determine if they should purchase the stock of companies represented by the index.
Because an index is a collection of many companies, sometimes thousands of companies, each of the companies in the index must represent a mathematical value so the index can measure the performance of the included companies and provide an accurate picture of the market’s trend.
Think of the U.S. House of Representatives for a moment. A state with low population, like Montana, has only 1 representative while a more populous state like California has 53. It’s the same with a stock market index; each company receives a weighting based on its mathematical value within the index.
Two Types of Indexes:
- The first type is the price-weighted index. A price-weighted index like the Dow Jones Industrial Average uses each company’s stock price as its proportional value to the overall average. With a price-weighted index, stocks with higher prices have more impact on the average than stocks with lower prices. If one company’s price-per-share is $60 while another company’s price-per-share is $20, the decline of 1% in the more expensive stock will have a more profound effect on the average than a decline of 1% in the less expensive stock.
- The second type of index is market capitalization-weighted. The NASDAQ Composite Index and the S&P 500 are examples. The index average is based on the relative size of each company in the index. Large-cap stocks have more influence on the index average than stocks with lesser capitalization. When a $5 billion company gains 1%, its influence on the index is more profound than a 1% gain by a $1 billion company.
As you can see, these two different types of indexes represent alternatives for calculating the performance of a market segment, offering insight from different perspectives.
What Is the Real Value of a Stock Market Index?
A performance average has value for some investors, but not for others. It depends on your investment philosophy. Some investors prefer a passive investment style and will purchase funds that mirror the performance of a particular index. For example, a passive investor may choose to purchase a small cap index fund because the investor’s research indicates that small-cap companies may soon enter a growth cycle. The passive investor’s fortunes rise and fall with the average performance of all the companies included in that fund. When the index does well, so does the investor; when the index declines, the investment declines as well.
An active investor will study the stock market indexes as a means for understanding a particular market segment in general, but will choose to purchase stocks that are calculated to offer more opportunity for profit than the average fluctuations of a market index. This will be the subject of a future blog, though, if you are interested in knowing more about active investing, please contact me for an eye-opening conversation.
What Are Some of the More Predominant Stock Markets in the U.S.?
Here’s a short list of some of the more popular stock market indexes:
- The Dow Jones Industrial Average: This index is composed of the 30 most dominant companies in the United States. (Also known as the Dow, and DJIA.)
- The S&P 500: Composed of the 500 most-traded stocks in the United States. (Also known as the Standard & Poor’s 500.)
- The Wilshire 5000: Representing 5,000 companies headquartered in the United States, this index is regarded as a total market index because it includes almost all publicly-traded companies.
- The NASDAQ: The NASDAQ Composite Index is a technology company index. This index includes some companies that are not headquartered in the United States. Because it also contains a number of small- cap companies, it is regarded by investors as a more speculative index.
- The Russell 2000: This index became popular when small-cap companies surged in the 1990s. It is composed of the 2,000 smallest companies in the Russell 3000’s largest publicly-traded companies.
Which International Stock Markets Are Important to Follow?
Internationally, these five stock market indices are a good starting point for following the performance of international companies:
FTSE: The Financial Times Stock Exchange 100 Index is the United Kingdom’s stock market index, listing 100 of the largest capitalized companies on the London stock exchange.
DAX: The Deutscher Aktienindex is composed of 30 major German companies available on the Frankfurt Stock Exchange.
CAC 40: This French index measures the capitalization-weighted performance of the top 40 of the top 100 market caps on the Euronext Paris. CAC stands for Cotation Assistée en Continu.
Shanghai Composite Index: Also known as the SSE, or Shanghai Stock Exchange, this index represents the top 50 Chinese companies as measured by market capitalization.
Nikkei: Japan’s Nikkei 225 Stock Average consists of the top 225 companies traded on the Tokyo Stock Exchange.
Monitoring the performance of these international stock indices can be helpful for understanding international economic influences that may have bearing on the United States stock market. Because we live in a global economy in which a nation’s financial performance often relies on activity in other markets, staying informed is part of the texture of being an astute investor.
This overview of stock market indexes should be a good starting point for your further examination. Indexes have value for investors who wish to take an informed role in either monitoring or actively developing their portfolio’s performance and growth.
If you would like to engage in a discussion on the nature of stock market indexes and how your portfolio is affected by these ever-changing market averages, or how to develop a portfolio that may create wealth in excess of average market performance, please call me. I would enjoy discussing opportunities for developing your financial security and growth.