en 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, which means that if a stock’s price changes by $1, it has the same effect on the index, regardless of the percentage 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 many stock splits over the years. If you know how to adjust 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 telling signal. Big changes in the Dow can indicate high investor confidence in stocks. But keep in mind that due to its makeup, it does not represent investor sentiment regarding any small or mid-size companies.
The S&P 500
The S&P 500 is the most frequently used index by financial professionals as the closest representation of the true market. It includes 500 of the most widely traded stocks, and leans toward larger companies. This index covers about 82% of the market’s total value, so in those terms, it is a better measure of the true market than the Dow is. The S&P 500 is a market-cap weighted index, as are almost all of the other major indexes.
The market capitalization, or "market cap," is the total value of company's outstanding shares. It can be used to measure a company's size in the market, as compared to others.
Weighting by market cap gives larger companies more sway in the index numbers. When Microsoft's stock goes up or down, for instance, those changes will have a greater impact on the index price than almost any other stock in the index. Even though the S&P 500 is weighted toward larger companies, since it includes so many companies, it is a more accurate gauge of the broader market than the Dow.
So, while the financial media may report more often on the Dow, you can get a better sense of the total market by focusing on the S&P 500.
The Nasdaq Stock Market Composite
The Nasdaq Stock Market Composite includes all of the stocks listed on the Nasdaq market, which totals more than 2,900 compani