Every evening news broadcast mentions the Dow or the S&P 500. But what exactly are these numbers? Stock market indices act as thermometers for the economy, measuring the health of specific market segments.
These benchmarks help investors track overall market performance without monitoring thousands of individual stocks. They also provide standards to compare your portfolios returns against the broader market.
What are stock market indices
An index tracks a group of stocks to measure how that market segment performs. Think of it as a shopping basket filled with selected stocks. The baskets total value rises and falls based on the stocks inside.
Charles Dow created the first stock index in 1896 with just 12 industrial companies. Today thousands of indices exist, each tracking different market segments, sectors, or investment strategies.
You cant directly buy an index. Instead, you invest in index funds or ETFs that mirror the indexs composition. These investments let you own a slice of every company in the index with a single purchase.
Indices use different calculation methods. Some weight stocks by price while others use market capitalization. This affects which companies have more influence on the indexs movements.
The S&P 500 explained
The Standard & Poors 500 tracks 500 large American companies across all major industries. It covers about 80% of the US stock markets total value, making it the broadest measure of large-cap American stocks.
This index uses market-cap weighting. Companies with higher total values affect the index more than smaller ones. Apple, Microsoft, and Amazon hold the biggest weights because their market caps exceed most other companies.
Getting into the S&P 500 requires meeting specific criteria. Companies need adequate liquidity, public float, positive earnings, and US headquarters. A committee reviews candidates and decides which companies join or leave.
Most professional money managers use the S&P 500 as their performance benchmark. If your mutual fund returned 8% but the S&P 500 gained 12%, your fund underperformed despite making money.
| Index | Number of Stocks | Weighting Method | Focus |
|---|---|---|---|
| S&P 500 | 500 | Market-cap weighted | Large US companies |
| Dow Jones | 30 | Price-weighted | Blue-chip US companies |
| NASDAQ Composite | 3,000+ | Market-cap weighted | NASDAQ-listed stocks |
| Russell 2000 | 2,000 | Market-cap weighted | Small-cap US stocks |
The Dow Jones Industrial Average
The Dow tracks just 30 large American companies. Despite its small size, it remains the most quoted index because of its long history and name recognition.
Unlike most modern indices, the Dow uses price weighting. A $300 stock moves the index more than a $50 stock, regardless of company size. This quirk means smaller companies with expensive shares can outweigh giants with cheaper stock prices.
The Dows companies represent established blue-chip corporations. Think Disney, Boeing, Coca-Cola, and Goldman Sachs. These businesses dominate their industries and have operated for decades.
The Wall Street Journal editors select Dow components without strict rules. They aim for companies that reflect the American economy. Changes happen rarely - the index has only swapped out a handful of companies in the past decade.
The NASDAQ Composite and NASDAQ 100
The NASDAQ Composite includes virtually every stock listed on the NASDAQ exchange - over 3,000 companies. Technology and biotech stocks dominate this index, making it more volatile than the S&P 500.
Tech giants like Apple, Microsoft, Amazon, Alphabet, and Tesla hold massive weights in the NASDAQ. When technology stocks surge, the NASDAQ typically outpaces other indices. During tech selloffs, it falls harder too.
The NASDAQ 100 narrows down to the 100 largest non-financial companies on the exchange. This concentrated version provides pure exposure to major tech and growth companies while excluding banks and brokerages.
Many investors use the NASDAQ as a tech sector proxy. If you believe technology will outperform, NASDAQ index funds let you bet on that trend without picking individual stocks.
How to use indices in your investing
Indices help you gauge your portfolios performance. Calculate your returns over the same period as an index, then compare. If you lag behind consistently, index funds might serve you better than active stock picking.
Use indices to understand market sentiment. When all three major indices drop together, broad market concerns exist. If only the NASDAQ falls while the Dow rises, investors might be rotating from growth to value stocks.
Index funds provide instant diversification at low cost. Instead of researching individual stocks, you can buy one fund holding 500 companies. This spreads risk and typically costs less than 0.1% annually in fees.
Different indices suit different goals. Young investors might prefer NASDAQ exposure for growth potential. Conservative investors often favor S&P 500 funds for balanced exposure. Some investors combine multiple indices to capture the entire market.
Rebalancing matters when investing in multiple indices. If the NASDAQ doubles while the Dow gains 20%, your portfolio becomes tech-heavy. Selling winners and buying laggards maintains your target allocation and locks in gains.
Understanding indices transforms you from a passive news consumer into an informed investor. At InvestStock Pro, we help clients build portfolios using index funds and individual stocks. Contact us to learn how indices can strengthen your investment strategy.