Learn What Market Indexes Say About Investing

Reflection of stock market index in window
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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.

Key Takeaways

  • 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.

Pros
  • Can reveal investing trends

  • Offers quick snapshots

  • Unified way to measure and compare

Cons
  • Human error

  • Errors build on each other

  • Weighted by size

Index Pros

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, even if they don’t tell the whole story.
  • Indexes provide a yardstick for comparison over time. They create a system that has widespread use, and so markets from all over the world can use the same language, or number systems or compare markets over time as well.

Index Cons

Indexes, by design, have what some people might think of as major flaws. In fact, there is debate among many traders as to whether you should rely too heavily on the indexes when making investing decisions.

  • People decide which stocks to include and which to remove, and people make mistakes. Sometimes stocks get included that shouldn’t be, and stocks get removed that shouldn’t be, for many reasons.
  • To make matters worse, the same flawed process of choosing which stocks belong in an index repeats year after year, which makes it difficult to look back and compare the S&P 500 of 1995 with the S&P 500 of 2004, for instance.
  • By weighting the indexes by size (except for the Dow), large or even giant companies are disproportionately represented. The way they perform will have greater impact on the index number than others. If one of them has a bad day, it can throw off the whole index.

The Three Major Indexes

There are many indexes all over the world that report on financial information about specific countries, regions, or sectors, and many that report on global markets. Here are the most well known, and the market sectors they capture.

The Dow Jones Industrial Average (DJIA)

The Dow Jones Industrial Average is the oldest and most widely known index. It is also the most widely quoted index. Often, whether rightly or wrongly, the Dow is often thought of as the market barometer.

At first, the Dow was a simple average of the stock prices in the index, but thanks to stock splits, spin-offs, and other transactions, the index now requires a more sophisticated price-averaging calculation. The Dow currently holds 30 stocks. These stocks represent some of the largest and most influential companies in the U.S.

The Dow is the only major index that is price-weighted, which means that if a stock’s price changes by $1, it has the same effect on the index, regardless of the percentage change for the stock. In other words, a $1 change for a $30 stock has the same effect as a $1 change for a $60 stock.

The calculation of the Dow takes into account many stock splits over the years. If you know how to adjust the math, it is possible to keep a historically viable index meaningful.

The Dow stocks represent about one-quarter of the value of the total market, so in that sense, it is a telling signal. Big changes in the Dow can indicate high investor confidence in stocks. But keep in mind that due to its makeup, it does not represent investor sentiment regarding any small or mid-size companies.

The S&P 500

The S&P 500 is the most frequently used index by financial professionals as the closest representation of the true market. It includes 500 of the most widely traded stocks, and leans toward larger companies. This index covers about 82% of the market’s total value, so in those terms, it is a better measure of the true market than the Dow is. The S&P 500 is a market-cap weighted index, as are almost all of the other major indexes.

The market capitalization, or "market cap," is the total value of company's outstanding shares. It can be used to measure a company's size in the market, as compared to others.

Weighting by market cap gives larger companies more sway in the index numbers. When Microsoft's stock goes up or down, for instance, those changes will have a greater impact on the index price than almost any other stock in the index. Even though the S&P 500 is weighted toward larger companies, since it includes so many companies, it is a more accurate gauge of the broader market than the Dow.

So, while the financial media may report more often on the Dow, you can get a better sense of the total market by focusing on the S&P 500.

The Nasdaq Stock Market Composite

The Nasdaq Stock Market Composite includes all of the stocks listed on the Nasdaq market, which totals more than 2,900 companies. Though broad in coverage, the Nasdaq leans towards tech companies. It is also a market. cap-weighted index and therefore most heavily influenced by very large tech companies.

The influence and the population of small, speculative companies in the Nasdaq make the index more volatile than either the Dow or the S&P 500. The Nasdaq wasn’t designed to represent the overall market, but it does provide good insight into the mindset changes of people who invest in technology.

Other Indexes

There are a number of other indexes that measure larger or smaller sections of the market. Mutual fund investors can also find funds that track almost any index they want. The major three indexes above, however, will serve most investors well. Should you want to look at other indexes to compare, make sure you have a good idea of how each index is weighted. Most, if not all, will be weighted based on market cap. You should also know how the index selects the stocks it holds.

The Balance does not provide tax, investment, or financial services or advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.