Learn What Market Indexes Say About Investing

Reflection of stock market graph in window
••• Hiroshi Watanabe/ Taxi Japan/ Getty Images

If you read or listen to the financial media, you might get the impression that the Dow Jones Industrial Average, usually referred to as the Dow, represents the pulse of the market. Other stock indexes like the S&P 500 or the Nasdaq Composite also get mentioned more or less often, depending on their numbers.

These and other reported indexes can give you a good amount of information and insight to use in making more informed investing decisions.

Explaining Index Numbers

First, take a look at what an index number represents. Although there are different ways to calculate index numbers, the numbers always represent a change from an original or base value. The base value represents the weighted-average stock price of all the stocks that make up the index.

The index number has much less importance or meaning than its percent change over time. This movement up or down gives you an idea of how the index is performing. Is the Dow up or down? The index gets calculated on an ongoing basis each day during the stock market’s open hours, to give investors a sense of direction for the market the index represents.

Be aware, though, that most stock indexes, even those quoted as representing the total stock market, only reflect a portion of the actual market. This happens because each index typically holds stocks from certain sectors or categories of the market.

Reading the Indexes

Keep these factors in mind when analyzing and interpreting changes in a given index:

  • Indexes don’t represent the total market. No matter what happens with the big three indexes, stay focused on your stocks or targets for evaluation. 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 some of the financial news commentators, you might think the indexes move on emotion. Investors may want to trade on the expectation of good or bad news, but index movements require actual trades, not just investor feelings.
  • Focusing on day by day, hour by hour, minute by minute clicks of an index makes for a good way to eat up valuable time.
  • Indexes provide a better historical perspective, rather than a forecasting vehicle. They can be especially helpful when viewed over a long historical period when researching trends.

The Informational Pros and Cons

Indexes provide useful information including:

  • 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.

Indexes, by design, have some seemingly major flaws that make them suspect to some investors as representative of any truly useful information.

  • People decide which stocks to include and which to remove and people make mistakes. Sometimes stocks get included that shouldn’t be and stocks are removed that shouldn’t be, for various reasons. In addition, this process repeats year after year, making it difficult to look back and compare the S&P 500 of 1995 with the S&P 500 of 2004.
  • By weighting the indexes (except for the Dow) by size, disproportion representation goes to large or giant companies. If one of them has a bad day, it can throw off the whole index.

    The Major Indexes

    The following summarizes the most popular indexes and the market sectors they capture:

    The Dow Jones Industrial Average (DJIA) is the oldest and most widely known index. It is also the most widely quoted index and often, whether right or wrong, considered the market barometer.

    Originally, it 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. You can find more information at the Dow Jones Indexes site. The Dow currently holds 30 stocks. However, 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 if a stock’s price changes by $1, it has the same effect on the index regardless of the percent 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 numerous stock splits over the years. By adjusting 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 factor and big changes can indicate investor confidence in stocks, however, it does not represent investor sentiment regarding any small or mid-size companies.

    The S&P 500 is the most frequently used index by financial professionals as a representative of the market. It includes 500 of the most widely traded stocks and leans towards larger companies.

    It covers about 70 percent of the market’s total value, so in those terms, it much more closely represents the true market than the Dow. The S&P 500 is a market capitalization or market-cap-weighted index, as are almost all of the other major indexes.

    Weighting by market cap gives more importance to larger companies, so changes in Microsoft stock 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, because it includes so many companies, it provides a more accurate gauge of the broader market than the Dow.

    Even though the financial media may emphasize the Dow, you can get a clearer picture of the market by focusing your attention on the S&P 500.

    The Nasdaq Stock Market Composite includes all the stocks listed on the Nasdaq market, which totals more than 5,000 companies. Although broad in coverage, the Nasdaq is heavily weighted to technology stocks. It’s a market cap-weighted index and stocks of very large companies like Microsoft and some of the other big technology companies influence the index.

    Their 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, however, it does provide good insight into the mindset changes of technology investors.

    Other Indexes

    A number of other indexes exist that measure larger or smaller sections of the market. Additionally, mutual fund investors can find a number of 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 for comparison, make sure you understand how the index is weighted (most, if not all, will be weighted based on market cap) and how the stocks held by the index were selected.

    The Balance does not provide tax, investment, or financial services and 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.