Indexes 101: A simple guide to Stock Market Indexes

The S&P 500, the NASDAQ composite, the Dow Jones… It's impossible to have lived a life on this Earth and not heard these names come up in the news. So what are these strangely named things. They are examples of stock market indexes. A tool used to track the stock price performance of a large market or narrow industry. This is the first in a series of articles that aims to demystify this concept so you can understand how to use indexes in your investment decisions. In this article we cover:

1. What a Financial Index is?
2. How does an index work?
3. Why are stock market indexes important to investors?
4. What are the common US stock market indexes?

What is a Financial Index?

In general, the noun index has two accepted definitions. The first is commonly found at the end of a book and is a list of alphabetically arranged names, subjects, etc. The second definition of an index is as a measurement of something. For example, students' grades from an important exam may serve as an index for a teacher's effectiveness. When discussing financial indexes (or stock market indices) we are concerned with that second definition. Financial indexes are a systematic method of measuring the performance of just about any group of securities (a tradable financial asset). Indexes can try to capture the performance of an entire market (serving as an indicator of an economy's state) or they can try to measure the performance of a specific sector/industry.

How does an index work?

The easiest way to describe this is by creating our own hypothetical index. Let's imagine that we want to track the price of a dozen eggs because we're an egg producer that wants to understand how to price our product. Right now, the average price for a dozen eggs is $5. The starting value of our index would be 1. 6 months down the line, the price for a dozen eggs is $7.50 because there has been a supply shortage pushing up prices. This is a 50% increase in the price of eggs and therefore our index will have risen by 50% to 1.5. This would be useful to us as an egg producer because instead of having to track and monitor competitor prices we could reference the index to see how we should change our own prices. For example, say we sell premium organic free range eggs that are priced high. When the index started our eggs cost $8/dozen, so now we should be charging $12/dozen (that's some expensive eggs!).

As previously mentioned, stock market indexes are used to track the performance of a market, industry, or sector. They are used for a variety of reasons that we'll explain next. Fundamentally, they are created by grouping a collection of assets and then tracking the cumulative value of these assets. Indexes are typically market-weighted or price-weighted. In a market-weighted index, every stock in the index is represented by relative market capitalization compared to the sum of market capitalization in the index. Price-weighted indexes often use an elaborately complicated method to determine the weights but fundamentally, the weight is determined by looking at the relative per share stock price compared with the total per share stock prices.

Why are Stock Indices Important to Investors?

We've learned that indices are a useful measure of how an economy, market, industry, or sector is performing but why is that useful to us as investors. Well, comparing the results of your investments against the performance of an index is a great way to see how you're doing. If for example, your investments are outperforming the index then you're doing well and vice versa. However, indexes are typically useful for longer term investing. Saying you beat the S&P 500 over 3 months isn't particularly useful. So, if your investments consistently outperformed the S&P 500 for 4 years then you're probably onto something good! Indexing is a form of longer term investing where managers pick stocks that mimic a particular index and then passively hold these stocks (these types of investors aren't actively picking stocks or trying to time the market, rather they are holding good companies for the long run).

Can I buy a Stock Market Index?

The short answer to this question is no. But that wouldn't give you the full picture. Index funds are investment vehicles set up to closely replicate the performance of an index. This allows investors to buy into the performance of a certain index. These index funds have a group of stocks that are almost identical to that of the index they are tracking.

What are the major stock market indexes?

In the US, there are 3 major stock market indexes that you've probably heard of. These are the S&P 500, the Dow Jones Industrial Average, and the NASDAQ composite. Here's a brief summary of what they track:

S&P 500

The Standard & Poor 500 (more commonly known as the S&P 500) is a US market capitalization index that tracks 500 of the largest companies listed on the US stock market. The total value of these stocks is worth roughly 80% of the total value on the US stock market.

Dow Jones Industrial Average

The Dow Jones Industrial Average (DJIA) is the second oldest index of the US stock market and it tracks the price performance of 30 hand selected companies that are all considered large cap. It's often criticized for the few number of companies it tracks and the fact that it is price-weighted.

NASDAQ Composite

The NASDAQ composite index is made up of approximately 2500 companies listed on the NASDAQ stock exchange. It is commonly referred to in financial news due to the broad range it covers. It's also known as the technology index because approximately 50% of the companies in the index are from the tech sector.

Rounding Up

Financial indexes track the performance of a broad based market or niche industry by tracking the price of a collection of securities in that sector or market. Looking at the performance of your passive investments against the performance of the relative indices gives you an idea of if you're under or over performing. Finally, the big three indexes in the US are the S&P 500, the Dow Jones Industrial Average, and the NASDAQ composite.In the next article, we will dive into the S&P 500 and some indexes by Standard and Poor.