. That is because each index typically holds stocks from certain sectors, such as tech, energy, or healthcare.
Reading the Indexes
Keep these factors in mind when looking at changes in a given index:
- Indexes don’t represent the total market. No matter what happens with the big three indexes, focus on your holdings, and assess your stocks or targets. Pick any day that all three indexes are down, and you will still see some stocks setting new highs that same day.
- Indexes react to actual trades. If you listen to financial news, you might think the indexes move on emotion. It's easy to get caught up in the hype or carried away in the ups and downs of the market. Even savvy investors may feel the urge to make trades based on good or bad news. But index movements require actual trades, not just investor hunches or feelings.
- Unless you're a rare breed of day trader, keeping a narrow view on the day-by-day, hour-by-hour, or minute-by-minute clicks of an index is not a useful way to assess the value of stocks. Instead, that is a good way to eat up valuable time.
- Indexes are not meant for quick forecasting. What they can do is provide a sense of historical context and past performance. When viewed over a long span of time, they may be able to help you spot patterns and research trends.
The Pros and Cons of Using the Indexes
Once you get used to reading an index, you'll have no problem getting the information you're after and weeding out the rest. But if you're new to the market, it's easy to get caught up in the rapid changes. So much information in number format can seem daunting. The indexes have a lot of good to offer, but they are not without flaws. Here are a few things to keep in mind when reading indexes.
Can reveal investing trends
Offers quick snapshots
Unified way to measure and compare
Errors build on each other
Weighted by size
Indexes provide useful information such as:
- Even with their limitations, indexes show trends and changes in investing patterns.
- They can give snapshots of market activity, even if they don’t tell the whole story.
- Indexes provide a yardstick for comparison over time. They create a system that has widespread use, and so markets from all over the world can use the same language, or number systems or compare markets over time as well.
Indexes, by design, have what some people might think of as major flaws. In fact, there is debate among many traders as to whether you should rely too heavily on the indexes when making investing decisions.
- People decide which stocks to include and which to remove, and people make mistakes. Sometimes stocks get included that shouldn’t be, and stocks get removed that shouldn’t be, for many reasons.
- To make matters worse, the same flawed process of choosing which stocks belong in an index repeats year after year, which makes it difficult to look back and compare the S&P 500 of 1995 with the S&P 500 of 2004, for instance.
- By weighting the indexes by size (except for the Dow), large or even giant companies are disproportionately represented. The way they perform will have greater impact on the index number than others. If one of them has a bad day, it can throw off the whole index.
The Three Major Indexes
There are many indexes all over the world that report on financial information about specific countries, regions, or sectors, and many that report on global markets. Here are the most well known, and the market sectors they capture.
The Dow Jones Industrial Average (DJIA)
The Dow Jones Industrial Average is the oldest and most widely known index. It is also the most widely quoted index. Often, whether rightly or wrongly, the Dow is often thought of as the market barometer.
At first, the Dow was a simple average of the stock prices in the index, but thanks to stock splits, spin-offs, and other transactions, the index now requires a more sophisticated price-averaging calculation. The Dow currently holds 30 stocks. These stocks represent some of the largest and most influential companies in the U.S.
The Dow is the only major index that is price-weighted, 