A stock market index is a measurement of a portion of the stock market. It is calculated from the prices of selected stocks (often a weighted average). It is a tool used by financial managers and investors to describe the market, and to compare the return on specific investments. Below you will find an interactive chart of some of the world's largest stock indexes. How to invest using a market index.
When investors watch any financial news network, browse a financial web site or hear a market update, they will undoubtedly hear about “the Dow, the S&P, and the Nasdaq." These three benchmarks are all examples of a market index. A market index provides a snapshot of market activity. Some benchmarks, like the ones listed above, provide a view of the entire market. Other index funds and there are over 5,000 of them, have a much narrower focus. The goal is the same. To give investors a summary of what is going on in the broader market or within a specific segment of the market.
Although an investor cannot invest money directly into a market index, they can attempt to match the index’s performance by investing in a mutual fund or exchange-traded fund (ETF) that uses an index as a benchmark. The popularity of index fund investing has created a wide market for these funds. Not surprisingly the number of funds has also increased. Index funds provide investors with a form of diversification and can also take a little of the risk out of speculating in emerging markets.
While no one index is considered the best, the three listed above (the Dow, S&P 500, and Nasdaq, along with the Russell 3000 index) are generally considered good barometers for the broader market)
Many students take advantage of SparkNotes (or CliffsNotes if you're of a certain age). These study guides provided a quick summary of a book we either didn't want to read or one we fell behind in reading. While they don't provide all the nuance of reading a book, they can hit on the main themes and give us a basic overview of what the student needs to know. For investors, market indexes serve as a form of SparkNotes for the market. While not providing all the information an investor will need, they can often be a useful guide for understanding where the money is moving in the market. In this article, we'll define a market index and why they are important. We'll also go into some detail about the significance of the weighting methodologies they use and give an overview of index mutual funds and ETFs that peg their performance to the performance of a particular index.
What is a market index?
A market index is a theoretical portfolio of investment holdings that represent a particular segment of the financial market. The value of the index is determined by calculating the prices of the underlying holdings. In most cases, the index uses a form of weighting which is a way to adjust the individual impact of any single component of an index. The most common types of weighting are market-cap weighting, revenue-weighting, float-weighting, and fundamental-weighting. Investors cannot invest directly in an index, so these indexes are used as benchmarks for creating indexed mutual funds and exchange-traded funds (ETFs).
Why are market indexes important?
Stock market indexes act as indicators for national economies and the global economy as a whole. The three most commonly recognized indexes in the United States are the S&P 500, the Dow Jones Industrial Average (otherwise called the Dow), and the Nasdaq Composite. However, there are approximately 5,000 indexes for U.S. equity markets alone. Many of these indexes have a very specific focus that can be based on a specific sector (e.g. biotech, utilities) or investment objective (e.g. fixed income, growth). Some indexes also focus exclusively on international stocks (e.g. the FTSE 100).
In the bond market, the U.S. Aggregate Bond Market Index is considered to be one of the most popular proxies for U.S. bonds.
Indexes are used by investors and investment managers as one of many performance benchmarks. Indexes are also the basis of passive index investing which take the form of indexed mutual funds and exchange-traded funds that track specific indexes.
Why are market indexes weighted?
Weighting is a way of making the index more representative of the overall market. In that way, a stock market index is like the Electoral College. Areas with a higher population are assigned more electoral votes. This is why the same states are “battleground” states in every national election.
In the same way, a stock market index assigns a weighting methodology based on what the creator of the index deems to be most appropriate. For example, in a price-weighted index, a small price change in a stock that is trading at $30 would have less impact on the index than the same price change in a stock that is trading at $100. The Dow Jones Industrial Average (DJIA) is an example of a price-weighted index.
A market-cap weighted index, by contrast, will assign more significance to the price movement of companies that have the largest market capitalization. A company's market cap is simply the value of a single share multiplied by the number of total shares outstanding (i.e. the number of shares available to be publicly traded).
How to invest using a market index
Investors cannot invest directly in a market index. However, there is a wide range of mutual funds and exchange-traded funds (known as index funds) that tie their performance to a specific index. In the case of a passively managed fund, the fund manager is simply trying to ensure that the performance of the fund matches the performance of its corresponding index. In an actively managed fund, the fund manager will attempt to outperform the fund's corresponding index.
What are the benefits of investing in a mutual fund or ETF that is tied to a market index?
Two of the greatest benefits to investing in index funds are diversification and the ability to speculate in emerging markets with less risk. Diversification is one of the best ways for investors to manage risk in their portfolio. In a diverse portfolio, an investor can divide their assets among different asset classes and even within an asset class based on their risk tolerance. The opportunity to get this kind of diversification is a primary reason investors will frequently choose to invest in an index fund as opposed to selecting individual stocks. For example, an investor who was looking to have a portfolio that was 70% stocks and 30% bonds could choose to invest 70% of their funds in an S&P 500 ETF and 30% in a U.S. Aggregate Bond ETF.
Index fund investing can also allow investors to minimize their risk when investing in emerging markets. Blockchain, cannabis, clean energy, and artificial intelligence are just some of the popular emerging sectors that have mutual funds and ETFs specifically indexed for those technologies. Although an investor may not be up to speed with these technologies, investing in an index fund is a way to speculate while balancing the fear of missing out with the inherent risk of these stocks.
Which market index is the best?
Investors who are unfamiliar with the concept of a stock market index may wonder why there are 5,000 or more of these indexes. And if so, why can’t an investor look at just one or two?
The answer is that just like every investor is different so are market indexes. Every investor has a different risk tolerance and time horizon. They may also have different goals and areas of expertise. One of the common axioms of investing is to invest in what you know. Some investors are much more comfortable investing in tech stocks. Other investors want to stick with different sectors such as health care or transportation. As the concept of market indexes has taken root with investors so has the demand for indexes that fit their style of investing.
So the answer to the question of which market index is the best depends on what information the investor is looking for. Here however is a basic look at some of the most frequently watched indexes for the broader economy.
The Dow Jones Industrial Average (DJIA) - “The Dow” as this index is frequently referenced to is the oldest of the major stock exchanges and has instant name recognition. The Dow is an index of 30 companies that are chosen by the editorial board of the Wall Street Journal. Every effort is made to ensure that the Dow represents a cross-section of the economy, but the 30 Dow components are not necessarily the largest ones. For example, while Apple is listed, Amazon and Alphabet (Google) are not. The DJIA is also a price-weighted index. This means that stocks with a higher share price will have a greater effect on the index.
The S&P 500 Index– As its name suggests, the S&P 500 is an index of 500 companies. In contrast to the DJIA, the S&P 500 index is weighted by market capitalization (companies with a larger market cap have a greater effect on the index). However, the S&P 500 includes only large-cap stocks. This means it excludes small- and mid-cap companies that can have a significant impact on the economy. For investors who are looking for a more narrow focus, the S&P also offers the S&P 500 Growth Index for stocks that exhibit more growth characteristics (think Apple, Amazon, Facebook, etc.) and the S&P 500 Value Index for stocks that exhibit more "value characteristics" such as are likely to be found in many blue-chip stocks (think Berkshire Hathaway, AT&T). The S&P 500 also has a dedicated mid-cap and small-cap index.
The Nasdaq Composite Index– This is commonly referred to as just the Nasdaq. This index includes every stock that is traded on the Nasdaq exchange (currently over 3,000 stocks). The Nasdaq is a market-cap weighted index. Some compelling features of the Nasdaq are its focus on the technology sector (nearly half the index is composed of tech stocks) as well as that it contains some international stocks. Like the S&P 500 Index, there are other Nasdaq-based indexes such as the Nasdaq 100 which features the largest 100 stocks listed on the exchange. The Nasdaq 100 does not include any financial companies by design.
The Russell 1000, 2000, and 3000 Indexes– There are three separate indexes that when put together provide what is considered to be one of the most complete snapshots of the market. The Russell 1000 includes the largest 1000 companies in the market. The Russell 2000, by contrast, focuses exclusively on 2000 small-cap U.S. companies. The median market cap of a company in the Russell 2000 is $933 million. Small-cap stocks are generally more volatile than large-cap stocks but have a track record of providing better performance. The Russell 3000 brings all of this together in an index that combines the stocks from the Russell 1000 and Russell 2000 indexes.
The bottom line on market indexes
Market indexes allow investors to see what's going on in the entire market by providing snapshots of different sectors. Is a rally being fueled by growth stocks or value stocks? Is the decline in the FAANG stocks isolated to the tech sector, or perhaps an indication of a broader sell-off? These are questions that market indexes can allow investors to answer. One of the easiest ways for an investor to tie their portfolio to a specific market index is by investing in a mutual fund or ETF that uses a specific index as the benchmark for its performance.