What Are Stock Market Indices?

Updated on September 20th, 2019

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You’ve probably heard of names like the Dow Jones, S&P 500, and the Nasdaq Composite being used frequently in daily financial news or even in general conversations about the stock market, but what do these names represent?

The Dow Jones, S&P 500, and the Nasdaq Composite are the 3 main stock indices in the United States. A stock index is simply a measure of the performance of a group of stocks. Stock market indices are mainly used as indicators of how a specific country’s stock market and economy are performing.

Stock market indices are also used as benchmarks for investors to compare the performance of the stocks they own. For example, an investor with a strong stock portfolio will match or outperform the performance of the index it is being compared to. There are hundreds of stock market indices around the world such as the DAX which measures the performance of 30 major German companies on the Frankfurt Stock Exchange and the Nikkei which measures the performance of the 225 most important companies in Japan, but let’s take a closer look at the top 3 indices in the United States.

The Dow Jones

First let’s look at The Dow Jones Industrial Average or more popularly known as “The Dow Jones” or simply “The Dow”. The Dow was created by journalist Charles Dow in 1896 and was named after himself and his business partner Edward Jones. The Dow is a price-weighted average of 30 large, established, and actively traded U.S. stocks. The Dow includes popular blue-chip stocks like Apple, Coca-Cola, McDonald's, and Nike that trade on the New York Stock Exchange and the NASDAQ.

The Dow will be represented as one, very large value that will increase or decrease based on the movement of the 30 stocks within the index. But all 30 stocks do not have the same influence on the value of the Dow. As a price-weighted index, the stocks in the Dow with the highest stock prices weigh more heavily on the value of the index. For example, a price change in a $100 stock will have more effect on the value on the Dow than an equal price change in a $50 stock would.

But with companies splitting their stock, merging with other companies, selling parts of their business, and even sometimes being removed from the Dow, the Dow isn’t just a straightforward calculation. The value of the index is calculated by adding the prices of the 30 stocks in the Dow and dividing by a set number that has become very small over time due to the events previously stated. This is why the Dow is represented by such a large number.

The Dow is one of the most closely watched indices in the world as it is an indicator of how shares of some of the largest U.S. companies are performing. Also since The Dow includes the top U.S. companies from multiple industries, it is commonly used as an indicator of how the U.S. stock market as a whole is performing. For instance, if the Dow has increased in value by the end of the trading day, investors will have expected the rest of the U.S. stock market to increase as well. If the Dow has decreased in value by the end of the trading day, investors will have expected the rest of the U.S. stock market to decline as well.

Although the Dow is popularly tracked, many experts argue that the Standard & Poor’s 500 Index, commonly known as the S&P 500, is actually the better indicator of the U.S. stock market and economy as a whole. This is simply because the Dow only measures 30 of the most important companies in the U.S while the S&P measures 500.

The S&P 500

Created in 1957, the S&P 500 is a market-capitalization weighted index including 500 of some of the largest U.S. companies on the New York Stock Exchange and the NASDAQ. The S&P 500 includes popular stocks like Apple, Microsoft, Amazon, Johnson and Johnson, and Facebook.

The value of the S&P 500 is calculated by adding the market capitalizations of the 500 stocks in the index and dividing by a set number determined by Standard & Poor’s. As a market-capitalization weighted index, companies with higher market capitalizations weigh more heavily on the index. For example, a price change in a stock with a $20 billion market cap will affect the value of the S&P 500 more than an equal price change in a stock with a $10 billion market cap. To calculate the market capitalization of a stock you just multiply the outstanding shares by the current share price; but no need to do this as market capitalization of every stock is usually provided for you.

The S&P 500 is known to be one of the most dynamic indices in the world with frequent changes in what stocks are included in the index. This is because the S&P 500 has specific criteria companies must meet to remain in the group. For example, requirements include being headquartered in the U.S. and having a market capitalization of at least $6.1 billion.

The S&P 500 is one of the most important indices in the U.S. because both individual and professional investors use the performance of the index as a gauge for the performance of their own stocks. The S&P 500 increased in value by 19.42% in 2017, so as an U.S. investor, a personal stock portfolio increase of 19.42% or higher would deem you a good investor for the year! Any personal gain below 19.42% would mean your stocks did not performance as well as they could’ve.

The NASDAQ Composite

Last but not least, the Nasdaq Composite Index was created in 1971, making it the new kid on the block. The Nasdaq Composite Index is a market-capitalization weighted index including roughly 3,000 securities listed exclusively on the NASDAQ stock exchange. This means that the stocks within the Nasdaq Composite Index can be headquartered outside of the U.S. but must be listed on the NASDAQ stock exchange.

The Nasdaq Composite Index has more securities than many other stock market indices. The Nasdaq Composite includes all stocks on the NASDAQ stock exchange unless they are warrants, rights, preferred stocks, ETFs, funds, derivative securities or convertible debentures. This is why the Nasdaq Composite is commonly referred to as just the Nasdaq.

The Nasdaq Composite is known for being majority technology stocks, including small speculative technology companies that have a relatively higher risk and reward. Investors mainly use the Nasdaq Composite as an indicator of performance for the technology & internet sector.

How to Invest in Indices

It is also important to realize that these three indices are not only just a great way to track the market, they can also be a great way to invest in the market! Through ETF’s, which are tradable funds that track a group of stocks, you can buy funds that track the performance of these three indices. The SPDR Dow Jones ETF (DIA) is the most popular fund for replicating the performance of the Dow. The S&P 500 can be invested in through popular ETF’s from SPDR (SPY), iShares (IVV), and Vanguard (VOO). And the Nasdaq Composite Index can be invested in through the well-known PowerShares ETF (QQQ) which tracks the 100 largest non-financial stocks on the NASDAQ.