What Is a Stock Market Index and How Does It Work?
A stock market index, also called a stock index, represents a securities portfolio that focuses on the stock market as a whole or a particular segment of the stock market. Indexes can have a broad or narrow focus, and the basket of stocks can replicate an economy, market, sector, commodity, or even a small group of stocks with a specific theme. Thus, a stock market index enables investors to track a particular market as easily as they can track a single stock.
The most popular stock market indexes in the U.S. are the Standard and Poor’s 500 index (S&P 500 index), the Dow Jones Industrial Average index (DJIA), and the Nasdaq Composite index.
When most stocks in an index go up, the index itself goes up as well, although some stocks in that index might be down. Thus, the index’s change represents the general upward or downward trend for stocks in that particular market or segment of the market. In other words, a stock index measures the performance or health of a particular group of stocks. When business is good, the index tends to rise. When business is bad, the index falls.
Investors use stock market indexes as benchmarks to which they can compare their portfolio’s performance. Investors also use indexes as low-cost, passive investments that increase diversification. It is impossible to invest in an index because an index is a hypothetical portfolio of stocks. However, investors can invest indirectly in an index by buying index funds, which are either mutual funds or Exchange Traded Funds (ETFs) that track a particular index.
Please note that stock market indexes are not the same as stock exchanges. Although both terms are often used interchangeably, they are two completely different things. A stock market index is a basket of equities designed to replicate a market or a segment of the market. A stock exchange is a physical location where stocks are traded. An example of a stock exchange is the New York Stock Exchange (NYSE). Some indexes track a particular stock exchange. For example, the Nasdaq Composite index tracks the performance of the stocks on the Nasdaq stock exchange in New York.
This article will discuss what a stock market index is, how an index is calculated, how it is used, how to invest in one, its pros and cons, and compares the most popular US market indexes.
Index Weighting Methodologies
A stock index measures the value of a basket of securities of a particular market or a market segment. Each stock in an index has a certain weight in the index it is part of. Stocks with higher weightings have more impact on the index’s value than those with lower weightings. The weighting of a stock gets assigned by the index provider. The three most common weighting methodologies used are:
1) market-capitalization weighting: The stocks held in this type of index are weighted by their market capitalization or the market value of their outstanding shares. A company’s market cap is calculated by taking the number of outstanding shares available in the market and multiplying them by the equity’s share price.
This means that the companies with the largest market value of the index can have a disproportionate impact on the index’s movement, up or down. Both the S&P 500 and the Nasdaq Composite are market-cap weighted, and the large companies in these indexes have much greater weightings than the smaller companies that make up the indexes.
As of December 31, 2020, per S&P 500, the top 3 companies in the S&P 500 made up 16.4% of the index. The top 3 companies are Apple Inc. with a weight of 6.7%, Microsoft Corp with a weight of 5.3%, and Amazon.com with a weight of 4.4%. This method of weighting remains the most commonly used method today.
Sometimes the market-cap methodology gets adjusted by only counting the publicly available outstanding shares instead of all the outstanding shares. This is called the float-adjusted market cap. This free-float method excludes all locked-in shares, such as those held by insiders, governments, and promoters. Both the S&P 500 and the Nasdaq composite are float-adjusted indexes.
2) Price weighting: A price-weighted index is an index in which the member companies are weighted in proportion to their price per share. A price-weighted index can be thought of as a portfolio with a single share of each constituent stock. This type of index gives a larger weight to shares with a higher stock price. The Dow Jones Industrial Average and the Nikkei 225 are examples of price-weighted indexes. It used to be that you could calculate the Dow by totaling the 30 share prices and then dividing that number by the number of companies in the index. However, events such as stock splits and spin-offs have made this number a lot harder to calculate.
3) Equal weighting: This type of index gives equal weighting to each stock, regardless of the stock price, market cap, or other factors. An equal-weight index tends to overweight small-cap stocks and underweight large-cap stocks compared to a market-cap weighted index. An example of an equal-weighted index is the Barron’s 400 Index that has assigned an equal value of 0.25% to each of the 400 stocks included in the index.
Tips on How To Read and Understand a Stock Market Index
Market indexes track stocks in a particular market or segment of the market and give a quick overview of that market’s overall movements and performance. Because there are so many different indexes available, it is important to understand how to interpret them. Each index has its own index value based on its value on its starting date. The value is based on market cap, stock price, or whatever weighting method an index has selected. This means that the starting value for each stock index is different because it is dependent on factors such as share prices, the number of outstanding shares, and the number of companies in the index.
Besides understanding how an index got its starting value, there are some other important factors to consider when following a particular index:
- Always read the index value change as a percentage change, not as a point change – For example, if one index increases by 100 points and another one by 30 points, it might seem that the first index performed better. However, let us assume that the first index started at 10,000 points, and the second one started at 1,000 points, then as a percentage change, the second index performed way better. The second index increased by 3% (30/1,000), whereas the first index only increased by 1%. (100/10,000). This percentage change will give you an idea of how the index is performing. Indexes change continuously in financial markets and are quoted in real-time during the trading day.
- Stock market indexes don’t generally measure the performance of the stock market as a whole – Knowing which stocks are in an index and how many companies are represented can give you a better idea of which segments of the market are contributing to that index’s performance. For example, it is important to know that the Dow Jones only represents 30 mostly blue-chip, large companies and does not include small-cap companies. The Dow could be down on a day that a small-cap index is up.
- Market indexes are useful when comparing them to historical index values but are not a great tool for forecasting – Comparing current market index numbers to historical index numbers can be very useful. For example, comparing the S&P 500 index value from this year to its value from one year ago shows how the US large-cap market performed this last year. Another example would be comparing the current Nasdaq index value to the Nasdaq’s previous low, which will show the Nasdaq’s recent uptrend performance.
Market Indexes as Benchmarks
Market indexes act as benchmarks that can be used for comparison reasons. There are approximately 5,000 different indexes in the USA. Wall Street’s three most popular indexes are the Dow Jones, which incorporates 30 of the US’s largest stocks, the S&P 500 Index, representing 500 of the largest US stocks, and the Nasdaq Composite Index, which includes about 3,000 stocks are listed on the Nasdaq exchange. Since all 3 indexes include stocks from large US companies covering all 11 sectors and most industries, they represent the overall US stock market and even the US economy. As a result, these indexes are widely used by US investors and analysts and on a global basis.
Other indexes are more specific and have a more narrow focus. For example, an index might focus on a specific market sector such as the S&P Healthcare Select Sector, or a specific stock type such as the S&P 500 Growth index, or a different geographic location such as a European index. These types of indexes will be helpful when an investor wants to see how a particular stock is doing compared to an index that covers the market that stock is in.
Important U.S. Stock Market Indexes
Market indexes can be categorized in many different ways. Here are some indexes organized by popularity, by stock type, and by market cap:
Most popular U.S. indexes
- Dow Jones Industrial Average (DJIA) – This index tracks 30 of the largest and most important US companies and is published by S&P Dow Jones Indices. The DJIA is the most widely used index in the world. It is price-weighted, and its constituent companies do not change as frequently as other US indexes. The Dow’s constituents are mostly large, blue-chip companies that focus on sustained growth and pay dividends. Although the Dow is an excellent representation of the blue-chip, dividend-value market, many people consider the Dow to be an inadequate representation of the overall U.S. stock market compared to broader market indexes such as the S&P 500 or the Russell 3000. Examples of companies in the Dow are 3M, Amgen, Home Depot, and Visa.
- S&P 500 Index – The S&P 500 functions as a barometer of the overall US stock market’s performance. It contains 500 of the largest companies weighted by float-adjusted market cap from across all market sectors and most industries. Examples of companies in the S&P 500 are Amazon, Facebook, and Berkshire Hathaway. The S&P 500 is considered a leading economic indicator of the performance of the U.S economy. In general, if the S&P 500 is doing well, the US economy will be doing well.
- Nasdaq Composite Index: This index is a market-cap weighted index of about 3,000 stocks traded on the Nasdaq stock exchange. The Nasdaq composite includes some companies that are not based in the USA and focuses predominately on technology. Unlike the S&P 500, some of its constituents are small and speculative, and some are large and less risky. It includes several subsectors, including software, biotech, semiconductors, and more. A Nasdaq composite movement represents the tech industry’s performance and a future outlook towards growth stocks.
- Russell 2000 – This index consists of 2,000 small-cap companies. It is widely regarded as the best benchmark on how smaller companies are performing. At the end of 2020, the average stock had a market cap of $2.3 billion, whereas the average market cap of a small-cap was just $933 million.
- Russell 3000 – The Russell 3000 is a total stock market index. It includes a combination of the Russell 2000 and the Russell 1000. The idea behind the Russell 3000 is to provide exposure to the entire US stock market, especially the small caps.
- Willshire 5000 – The Willshire 5000 includes all publicly traded companies with headquarters in the United States with readily available price data. It is considered a total stock market index. However, it is used less often than the popular S&P 500.
Indexes by stock type
- S&P 500 Value Index – This index consists of stocks in the S&P 500 that possess “value characteristics.” These are generally stocks that are traded for relatively low multiples of their book values and earnings. They also tend to be more mature, slower-growing companies. A few of the largest companies in this index include JP Morgan Chase, Berkshire Hataway, AT&T, and ExxonMobil.
- S&P 500 Growth Index – The stocks in this index are considered to have “growth” characteristics. While there are no specific cutoffs to distinguish growth stocks, they are generally companies that possess above-average sales growth and potential. These stocks typically have a relatively high price-to-earnings ratio. Some of the largest S&P 500 Growth Index’s companies include Apple, Amazon, Facebook, Alphabet (Google), and Visa.
- Nasdaq-100 – The Nasdaq-100 is one of the world’s leading large-cap growth indexes. It includes 100 of the largest domestic and international non-financial companies listed on the Nasdaq Stock Exchange. It is a market-cap based index.
Indexes by market cap
The S&P 500 is a subset of the total-market index of the S&P 1500. Other indexes that are subsets of the S&P 1500 include:
- S&P MidCap 400 – This index tracks the middle of the market. However, the eligibility is restricted to stocks with market caps between $1.6 billion and $6.8 billion. The mid-cap stocks are often seen as a balance between lower volatility and high long-term return potential.
- S&P SmallCap 600 – This index tracks 600 small-cap companies, although the Russell 2000 is a much more widely used index for small caps.
Market Indexes Outside of the US
Market indexes outside of the US can be divided into global, regional, and national indexes. A global index represents stocks from all over the world. The most widely used global index is the MSCI All Country World Index (ACWI). This market-cap weighted index tracks around 3,000 large- and mid-cap stocks in 49 countries and covers developed and emerging markets worldwide.
Besides global indexes, there are many different variations available for international investors to get exposure to the international market. For example, instead of focusing on the entire world market, they might want to target only a specific part, such as emerging markets. An example of an index that tracks emerging markets is the MSCI Emerging Markets Index.
Another way for international investors to diversify their portfolios is to invest in a particular country. An example of a country-specific market index is the Financial Times Stock Exchange 100 Index, called the FTSE 100. This is a share index of the 100 companies listed on the London Stock Exchange. Another example of a country-specific index is the DAX. This is a blue-chip stock market index consisting of 30 major German companies on the Frankfurt Stock Exchange.
How To Invest In an Index
While it is impossible to buy a share in an index because an index is a benchmark only and represents a hypothetical portfolio of stocks to track a particular securities market, there are several ways to invest in them indirectly and mirror their performance. This is called index investing. The goal of index investing is to replicate the returns of a market index.
The easiest way to mimic a particular index’s performance is to buy an index fund that tracks that particular index. Index funds are mutual funds or ETFs with a portfolio constructed to track or match a particular market index’s components. An index fund gives you exposure to the entire index by combining all the index companies into a single security.
While index mutual funds do charge management fees, those fees are usually low because they require minimum active management by the fund managers. Index ETFs trade like a stock. They offer the diversification of a mutual fund and the flexibility of a stock.
Index funds have several advantages. They require little management but offer high diversification at a low cost. Another advantage of index funds is that they offer low risk and steady growth. Index funds are inherently diversified. The fund’s securities usually represent various industries, protecting the investor against significant losses and reducing its overall risk. Index investing is a passive investment strategy that often outperforms most non-index fund strategies that try to beat the market over the long term. Index funds also offer tax advantages. They have a low turnover rate, which reduces taxes.
There is a wide variety of index funds and types to choose from. They include US index funds, international index funds, funds that focus on a particular sector, and bond index funds. Because of the variety of funds available, finding a fund that matches your investment goals should not be difficult.
Investing in an index fund is the easiest way to invest in an index. However, besides investing in an index fund, there are several other ways to invest in an index. You can try to replicate the index yourself by buying all the underlying stocks of a particular index. Of course, this will be very time-consuming, take a lot of effort and be expensive. Another way to invest in an index is to buy futures and options contracts of the index. Again, this requires experience, a lot of planning and can be costly.
The Pros and Cons of Market Indexes
- They provide an easy way to track the overall health of a market.
- Historical data of indexes show trends and changes in investing patterns in markets or market segments.
- They give an insight into the market activity, providing a comparison yardstick over time.
- They simplify the research process, especially for those who want to learn about the industry, economy, or sector performance.
- Investment managers use indexes as benchmarks for performance reporting.
- ETFs and mutual funds that track an index make it easy for investors to build a diversified portfolio.
- Each index serves a unique purpose because different investors are interested in different markets, sectors, and industries.
- The rise of index mutual funds and ETFs has helped fund managers use passive investing strategies to minimize costs and let investors tailor their portfolio exposure as precisely as they want.
- Sometimes stocks get included or removed from a stock index. This makes the year-to-year index comparison less accurate and more complex.
- Market indexes are not good tools for forecasting.
- Market-cap weighting gives the companies with the largest market value of the index a disproportionate impact on the index’s upwards or downwards movement.
- Most stock indexes, even those that state that they represent the total stock market, only reflect a portion of the actual market. For example, the S&P 500 is considered to be an index that represents the US stock market. It includes 500 of the largest US companies and represents all the industries and sectors. However, it does not include small-cap and mid-cap companies, so it does not really represent the total US stock market.
Market indexes provide valuable information to individual and institutional investors. They track the performance of a specific basket of stocks that represents a particular economy, market, sector, or industry. As a result, market indexes make it easier to track a particular market’s performance without having to check the performance of all the individual stocks in that market.
There are indexes for almost every possible industry and sector of the economy and stock market. Understanding the differences between indexes will help you make better investment decisions.
Market indexes have opened up investment opportunities in the stock market for even novice investors. Investors can invest in a particular index by buying an index fund that follows that particular index. Index funds are mutual funds or ETFs that track the performance of an index. Index funds are popular because they provide a diversified portfolio with broad market exposure, low operating expenses, and low portfolio turnover. Warren Buffett once said: “By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals.”