If you read or listen to the financial media, you might get the impression that the Dow Jones Industrial Average, often referred to as just "the Dow," serves as the pulse of the market. People who report on the market will often use the ups and downs in the Dow as a shorthand for the health of the market in general. Two other major stock indexes—the S&P 500 and the Nasdaq Composite—also get mentioned more or less often, depending on their numbers.
These three major indexes, along with others, can give you a good amount of insight to use in making more informed investing decisions. Here you'll learn how to read the numbers, as well as a few tips and tricks to better understand the major indexes.
- The market index number is less important than its percentage of change over time.
- Keep in mind that market indexes only represent a portion of the total market.
- Indexes are best used for looking back at historical context and not for forecasting.
Explaining the Index Numbers
First, let's take a look at what an index number represents. Although there are many different ways to calculate and display index numbers, each will always measure a change from an original or base value. The base value of an index is not a true measure of the value of stock but rather the weighted-average stock price of all the stocks that make up that index. It works like an anchor, or a benchmark, by which to compare all other value changes over a given time.
The index number has much less meaning than its percentage of change over time. This movement up or down gives you an idea of how the market for that index is performing on a broad level. For instance, you'll often hear simply that the Dow is up or down. The index number gets calculated on an ongoing basis each day during the stock market’s open hours. It helps to give investors a sense of direction for the market that the index number represents.
Be aware that most indexes, even those that serve the media as casual stand-ins for market health, only reflect a portion of the total market. 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, ev