Market indexes are statistical yardsticks that can be used to gauge the performance of a particular market or group of investments. Because indexes are designed to track the performance of different parts of the economy they are handy benchmark measures against which a particular investment can be judged.
The key thing about indexes is they are used to evaluate returns. So basically you would figure out how well your investments are doing – typically by evaluating their current price and adding up the cash they have produced and by comparing those totals to the market index. If your investment is significantly better or worse than the comparable index, you’ll want to know why. For example if your investment is consistently beating the market, it might be because it is taking on more risk than expected (such as in the case of mutual funds that speculate in high risk stocks).
Here are some of the key stock market indexes:
The Dow Jones Industrial Average
The Dow is the oldest most quoted market indicator in the United States. This index tracks the stock share price of 30 companies which best represent their industries. The market capitalization of the DJIA stocks account for nearly one quarter of the total U.S. stock market. The index is price weighted, so if one or two stocks do exceptionally well or exceptionally poorly the index can be pulled up or down significantly. Roughly two-thirds of the DJIA’s 30 component companies are manufacturers of industrial and consumer goods. The others represent diverse industries like financial services, entertainment and information technology. Even so, the DJIA today serves the same purpose for which it was created – to provide a straightforward view of the stock market and, by extension, the U.S. economy.
The S&P 500
The Standard & Poor’s 500 is one of the most commonly used benchmarks for the overall U.S. stock market. The index includes 500 leading companies in prominent industries of the U.S. economy. Although the S&P 500 focuses on the large -cap segment of the market, with approximately 75% coverage of U.S. equities, it is often used as a proxy for the stock market as a whole. Stocks are selected by a committee which evaluates the index on a periodic basis. The S&P 500 is capitalization-weighted which means that a big company like Exxon Mobile has bigger impact on the index than a smaller company like 1-800 flowers.
Despite its popularity, the S&P 500 does not cover emerging markets like China and Brazil. Like most stock indexes it doesn’t cover bonds, even though it’s often compared to the bond markets. Many index funds and exchange-traded funds track the performance of the S&P 500 by holding the same stocks as the index, in the same proportions. Because of this, a company which has its stock added to the list may see a boost in its price as the managers of the funds need to buy that company’s stock in order to match their funds’ composition to that of the index.
The NASDAQ Composite Index
The NASDAQ is often mentioned in the same breath as the S&P 500, but the NASDAQ is actually pretty different. For example, the NASDAQ covers far more companies – 5,500. The NASDAQ is often called “tech heavy” because the stocks in the index have historically been telecommunications or technology companies. The NASDAQ tends to be a bit more volatile than the Dow Jones industrial average, but it’s also been home to some large stocks like Google, Microsoft and Apple, Inc. Because of the NASDAQ’s heavy emphasis on telecommunications, technology, and financial companies, you can use the NASDAQ to get a handle on these dynamic markets. One thing to keep in mind is the NASDAQ doesn’t include finance companies and can include stocks from outside the United States.
The Russell 2000 is the most widely used benchmark for smaller company market. It includes approximately 2000 of the smallest securities based on a combination of their market capitalization. The Russell 2000 Index is constructed to provide a comprehensive and unbiased small-cap barometer and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the small cap market. The median market capitalization is around 700 million. As of 2013, the top market sectors reflected in the Russell 2000 are: Financial Services, Producer Durables, Consumer Discretionary, Technology and Health Care.
The Wilshire 5000
The Wilshire 5000 is mentioned less frequently than other indexes. This index is a total market index, which that it contains stocks from the large, medium and small company markets. It lists nearly every decent publicly traded stock, including companies in the New York Stock Exchange, the American Stock Exchange and the Nasdaq Composite. It does include REITS, but excludes American Depository Receipts (ADRs) and penny stocks. The Wilshire 5000 isn’t followed as closely as the S&P, but it does provide an overall broad sense of where the stock market is going. The Wilshire 5000 is market capitalization weighted, so big companies like Wal-Mart and Microsoft have more of an impact on the index.
S&P Mid Cap 400
The S&P 400 index serves as a barometer for the U.S. mid-capitalization stock sector and is the most widely followed mid-cap index in the U.S. To be included in the index, a stock must have a total market capitalization that ranges from roughly $750 million to $3.3 billion. The Index includes equities from all the major sectors of the U.S. economy including: energy, technology, healthcare, financial and manufacturing. Like many other stock market indexes, the S&P 400 Mid Cap Index is value-weighted, meaning that the stocks with the largest market capitalization have the most significant impact on the total index.