Historically, stock market indexes have been closely watched as an indicator of the market’s overall performance. While that role is still important, the number of stock market indexes has grown explosively as mutual funds and investment managers search for relevant indexes to use as benchmarks to compare performance. Indexes are also increasingly used as the base for investment products, allowing investors to invest in defined segments of the market without purchasing all of the underlying stocks in the index.
Indexes can be computed in different ways. Some, like the Dow Jones Industrial Average (DJIA) are calculated using an arithmetic average. The prices of stocks are added and then divided by the number of securities in the index, although the divisor is adjusted over time for the splitting of shares, distribution of stock dividends, and to account for company substitutions in the index. These indexes do not adjust for the company’s total market value, so stocks with the highest share prices have more impact on the index. Other indexes, such as the Standard & Poor’s 500 (S&P; 500), use market-value weighting, factoring in the differences in individual stocks’ market value by multiplying the price of each by the number of shares outstanding. Thus, major corporations have a greater influence on the index than small companies.
Another important calculation difference is whether the index is a capital return or total return index. A capital return index, such as the DJIA and the S&P; 500, only reflects changes in the shares of the stocks in the index. Total return indexes, such as the Russell 2000 and the Wilshire 5000, calculate both share price changes and dividend reinvestment.
Some of the major stock market indexes include:
The Dow Jones Industrial Average is comprised of 30 large-company stocks. All of the companies are billion-dollar giants, with no small- or medium-sized firms in the index. Despite the small number of companies in the index, the index is the oldest and most widely quoted measure of the U.S. stock market.
The Standard & Poor’s 500 is comprised of 500 large-company stocks trading on the New York Stock Exchange, the American Stock Exchange, and Nasdaq, covering a wide variety of industries. This index is considered more representative of the U.S. stock market than the DJIA. Additionally, various component indexes are calculated from this index, including the 400 industrials, 40 utilities, 20 transportation companies, and 40 financial stocks.
The Nasdaq Composite Index follows the approximately 5,000 stocks that trade on Nasdaq. This index is generally viewed as a good benchmark for technology stocks.
The Russell 2000 Index is viewed as a good benchmark for the performance of smaller-company stocks. The stocks in the index include the 2,000 lowest-capitalization stocks from the Russell 3,000, which includes the 3,000 largest-capitalization stocks in the U.S. stock market.
The Wilshire 5000 Index, despite its name, consists of over 6,000 stocks, including almost all stocks traded on major exchanges, and gives the broadest view of the U.S. stock market.
If you want to compare your investments’ performance to an index, select one that tracks the same types of stocks you hold in your portfolio. Keep in mind, however, that indexes do not incur any trading costs or taxes.