To build wealth, it’s important to understand what a stock market index is. It gives you useful insight into the overall health of the stock market. But it has its limitations… things it’s no good for. Find out how to use a stock market index to grow your wealth and live your dreams.
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When you start investing, growing your knowledge can help you build wealth. One thing that’s important to understand is what a stock market index is.
There are several stock market indexes. The main function of all of them is to show you how the market as a whole is behaving. To help you see the big picture. But in order for that picture to be accurate, you need to know a few things about the most common stock market indexes… because none of them are perfect tools.
If you listen to the financial news, you might get the impression that the Dow Jones Industrial Average – usually just called the Dow – is the be all and end all. The pulse of the entire market. But you’d be wrong. The Dow can give you insights and information. But it’s only a small piece of the puzzle.
Definition: What is a Stock Market Index?
A stock market index is basically a group of stocks with a composite numerical value that represents the value of all the stocks in that index. Think about the index of a book. It contains all the key words and thoughts of the book. A stock index is similar.
The stocks in each index are there by design. Usually based on some common factor(s).
However, not all stock market indexes are the same. They’re weighted differently. Each gives a different picture of reality based on how it is weighted.
Stock market index numbers all represent a change from some original or base value. This base value is a weighted-average stock price of all stocks in that particular index.
But the number isn’t what’s important. The percentage of movement over time is the main thing. And it’s important to keep the main thing, the main thing.
Note that a stock market index is not the same as the stock market itself. Stock indexes reflect only a part of the whole – regardless of assumptions people make. Each index contains stocks from specific sectors of the whole market.
Keep reading for how to interpret market index numbers. But first…
The Big 3 Stock Market Indexes
American investors hear mainly about these three indexes. It’s not that there aren’t others, in the U.S. or internationally. But these are the most-tracked and most-talked-about.
The Dow Jones Industrial Average (DJIA, or just the “Dow”)
The Dow is the oldest and most widely known index. Right or wrong, it’s considered the barometer of the U.S. stock market. However, it only represents 30 companies’ stock prices. They are some of the largest and most influential U.S. companies.
Interestingly, the Dow is the only major index that’s price-weighted – based on the price per share. Which means that the most expensive stocks hold more sway on the index than the cheapest stocks do. The Dow index factors in all stock splits over the years.
The DJIA only represents about a quarter of the value of the entire market. So it’s a decent (but certainly not comprehensive) indicator of market health. Big changes can indicate changing levels of investor confidence. But bear in mind that the Dow does not reflect investor sentiment toward small- or mid-sized companies.
The S&P 500
The Standard & Poor’s 500 – usually just called the S&P 500 – includes 500 widely traded stocks. It skews toward larger companies and covers 82% of total market value. So it indicates overall market health better than the Dow.
The S&P 500 is weighted by market capitalization, or market cap. Market cap is the total value of all a company’s investor-held shares. Stocks with a high market cap hold more influence than stocks with a smaller market cap. That means Microsoft and Apple exert greater impact on the index’s price than Tiny Company XYZ does.
Even though it skews toward large companies, the S&P 500 is a more accurate reflection of overall market sentiment than the Dow, because it tracks so many more stocks. Thus you should pay more attention to it.
Of these three indexes, the Nasdaq is the most volatile because of its number of small, speculative tech companies. Therefore, it might be a good reflection of the market sentiment of tech investors. But hardly so for investors as a whole.
What are Stock Market Indexes Useful for?
Beginning investors may conclude that stock market indexes don’t really serve much purpose. As you become a more experienced investor, you start to realize they can be quite useful, for the following reasons:
- Tracking these stock market indexes can give you a sense of the overall health of the stock market. A kind of measure of investing sentiment.
- Tracking indexes that follow a certain market segment can help you see how that particular segment is performing… which way it is trending versus the entire market.
- Index funds that track one of the indexes is the simplest way to get started investing. And also as a way to take a hands-off approach and simply match the performance of that index. It gives you diversification without having to study, select, and track individual stocks. As such, even novice investors can participate in the long-term success of the stock market with index funds.
How to Read Stock Market Indexes
The numbers given by an index have no meaning without context. They gain meaning by representing a change from an original or base value. This number is recalculated every day, so it’s ever-changing.
In addition, the index number is less important than the percentage of change over time.
In order to avoid misreading or misinterpreting index numbers, it’s important to understand what they can – or can’t – tell you. Keep these guidelines front and center when interpreting stock index numbers.
1. Stock market indexes do not represent every stock in the market.
They don’t necessarily show what’s happening to your own individual stocks. Pick nearly any day when all three indexes are down, and you’ll still see certain stocks reaching new highs.
2. Indexes represent real trades, not emotion.
Listen to financial commentators, and you’d think market indexes move up or down on pure emotion. It’s true that investors may trade based on good or bad news – or the expectation of such. But the indexes only move based on actual trades where money is on the line, not emotions.
3. Indexes are better at giving historical perspective than forecasting.
The best use of indexes is to give you the 30,000-foot view of sweeping trends… not a day-by-day, blow-by-blow analysis (which will ding your productivity and waste your time).
It’s important to realize that for all the discussion by commentators, indexes also have their limitations. You should know what they are so you don’t misread their signals.
Stock Market Index Pros and Cons
Indexes provide useful information, such as:
- Showing big trends and changes in investing patterns.
- Giving a snapshot of a particular point in time. Consider the family photo taken five years ago before three new babies were born. It was accurate then, but not now. Same with stock market indexes. They don’t tell the whole story.
- Providing context for your investing decisions.
- Revealing how your index fund is performing.
On the other hand, indexes have significant flaws that limit their usefulness.
- People choose which stocks to include, or not, in an index. And people can make mistakes. When stocks are added to or subtracted from an index time and again, that index loses some of its significance as a point of comparison.
- Large and giant companies are weighted more heavily (except in the Dow). Which means that when one of them has a bad day, it throws off the whole index.
- Talking heads can make too much of daily moves, while (often) ignoring larger trends.
Bottom line, you should know what stock market indexes are and what they can do for you. But don’t expect them to do what they can never do, such as predict the future. You’ll be a better investor for it.