Market Indexes: What Are They and How Do I Invest?

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You hear about the stock market everywhere these days – newspapers, television and radio and the Internet. What exactly does it mean when you hear the phrase “The market put out a great performance today?”

What the heck do we mean by the term “the market”?

Get this – when most people refer to “the market,” they are actually referring to an index.

Stocks are becoming increasingly important and ingrained in our society. We actually use names for market indexes such as the Dow Jones Industrial Average (DJIA), S&P 500 and Nasdaq composite as part of our everyday discourse.

In this how-to, I will define what an index is, discuss some of the major stock market indexes and then explain how you can invest in the stock market using index funds.

What the Deuce are Market Indexes?

An index is a statistical measure of the changes in a portfolio of stocks that is supposed to represent a portion of the overall market.

Consider this – It would be too difficult to track every single security trading in the country. To get around this difficulty financial experts take a smaller sample of the market that is representative of the whole. An analogy would be pollsters using political surveys to gauge the sentiment of the population.

Like pollsters, investors use market indexes to track the performance of the stock market. All things being equal, a change in the price of an index represents an exactly proportional change in the stocks included in the index.

The First Index

In May 1896, Mr. Charles Dow created the first and, consequently, most widely known index. In 1896, the Dow index contained 12 of the largest public companies in the U.S.

Today, the Dow Jones Industrial Average (DJIA) contains 30 of the largest and most influential companies in the U.S. Before the digital age and the benefit of computers, calculating the price of a stock market index had to be kept as simple as possible.

The original Dow Jones Industrial Average (DJIA) was calculated by adding up the prices of the 12 companies and then dividing that number by 12. Of course, these calculations made the index really nothing more than an average, but it served its purpose.

Today, the DJIA uses a slightly different methodology. This is called price-based weighting.

In the price-based weighting system, the weight of each security is the stock's price relative to the sum of all the stock prices. There is a problem with price-based weighting, however. The problem is that a stock split changes the weight of a company in the index. This occurs even though there is no fundamental change in the business. For this reason, not too many market indexes are weighted on price.

Most market indexes weigh companies based on market capitalization. If a company's market cap is $1,000,000 and the value of all stocks in the index is $100,000,000 -the company would be worth 1% of the index. It is only because of computers that these types of systems are made possible. Computers calculate to the minute, so these systems are very accurate reflections of the market.

An Index Is A Glorified List

An index is nothing more than a list of stocks; anybody can create one.

During the dotcom bull market, this was especially true. Just about every publication created an index representing a section of new economy stocks.

Big market indexes are set apart from the small ones by the reputation of the company that puts out the index.For instance the DJIA is owned by Dow Jones & Company, the same people who publish The Wall Street Journal.

Now that we've covered what an index is, let's take a look at some of the most popular stock indexes.

Dow Jones Industrial Average (DJIA)

The DJIA contains 30 of the largest and most influential companies in the U.S.

This is the most recognized index in the world. It is also the one that is often synonymous the term “the market”. The DJIA has some weaknesses as an overall benchmark for the market despite its popularity.

DJIA Details:

  • Created By – Charles Dow on May 26, 1896. Currently maintained by Dow Jones & Company.
  • Number of Companies – began with 12, today there are 30.
  • Types of Companies – Various. All major areas of the U.S. economy except the transportation and utility sectors are covered by this index.
  • Selection Criteria – At the discretion of The Wall Street Journal editors and reviewed as needed.

The original DJIA was simply an average of stock prices and as mentioned before it now uses a price-weighted system. As a quick example, McDonalds' stock is worth approximately 5% of the DJIA.

Some advantages and disadvantages of the Dow Jones Industrial Average.

Advantages:

  • The DJIA has stood the test of time.
  • Contains 30 of the most familiar blue chip companies in the U.S.
  • Not considered to be volatile or risky.

Disadvantages

  • There are well over 10,000 public companies in the U.S. Containing only 30 companies, the DJIA doesn't even come close to being a benchmark for the entire market.

Because the DJIA only covers 30 companies, the S&P 500 is beginning to take over as the benchmark of choice. Additionally, weighting based on market cap is generally thought to be more effective than price weighting.

The DJIA has several index funds that track it as well as an Exchange-Traded Fund (ETF) called the Dow Diamonds. This trades under the symbol DIA on the American Stock Exchange (AMEX).

As I mentioned above, the main drawback of the DJIA is that it is limited to 30 companies.

The S&P 500

The S&P 500 includes 500 companies as opposed to the DJIA’s 30 companies. The financial world increasingly sees this as the benchmark of the U.S. stock market.

The performance most equity managers is in fact, is pegged against the S&P 500.

S&P 500 Details

  • Created By – Standard and Poor's Index Services
  • Number of Companies in the index – 500
  • Types of Companies in the index – The S&P 500 tries to cover all major areas of the U.S. economy.
    • It is not the 500 largest companies, but rather the 500 most widely held companies – chosen with respect to market size, liquidity and industrial sector.
  • Index Selection Criteria – components are chosen by the S&P Index Committee.
    • Anywhere from 25-50 changes are made every year because of mergers or fallouts à la Enron.
    • International companies have been included in the past, but only U.S. companies will be added in the future.
  • How the index is calculated: The S&P 500 is a market capitalization-weighted index. This means every stock in the index is represented in proportion to its market capitalization.

Advantages of The S&P 500

The S&P 500 is one of the world’s best benchmarks for large cap stocks.

The index offers great diversification and accounts for approximately 70% of the U.S. market by including 500 companies.

The S&P 500’s performance is considered one of the best overall indicators of market health. Mutual fund managers set beating the index as their goal.

Disadvantages of The S&P 500

One disadvantage is that the top 45 companies in the index comprise more than 50% of the index's value.

There is very little foreign content to the index as well.

How to invest in the S&P 500

The S&P 500 has several index funds that track it – for instance, Vanguard’s fund. The Exchange-Traded Fund (ETF) that tracks the S&P 500 is Standard & Poor's Depository Receipts (spiders).

Nasdaq Composite Index

The Nasdaq Composite Index represents all the stocks that trade on the Nasdaq stock market.

Because of the uptick in popularity of technological stocks the Nasdaq has been thrust into the spotlight. As a result the composite index has become one of the premier market indexes in the world.

The Nasdaq Composite Index should not be confused with the Nasdaq 100. The Nasdaq 100 is made up of the 100 largest non-financial companies on the Nasdaq stock market.

Nasdaq Composite Index Details

  • Created By – The NASD in 1971
  • Number of Companies In Index – 3,000+
  • Types of Index Companies – All the companies that trade on the Nasdaq. These are mostly are technology and Internet-related; however there are financial, consumer, bio-tech and industrial companies.
  • Index Selection Criteria – If it’s traded on the Nasdaq, it is included in the index. There are certain restrictions on security types, i.e.
    • Close-end funds
    • Preferred stocks
    • Rights
    • Warrants
    • Convertible debentures

The Nasdaq Composite is a capitalization-weighted index, with each company weighting being proportionate to its market value.

The Nasdaq Composite Advantages:

The index is heavily weighted in technology and Internet stocks. These companies are considered to have high growth potential.

The Nasdaq Composite Disadvantages

The companies listed on the Nasdaq tend to be more speculative and risky. This is in opposition to those listed on the New York Stock Exchange (NYSE).

Therefor the Nasdaq composite index is much more volatile than other broad market indexes. The strength of being mostly tech can also be a weakness. In other words when tech does badly, so does this index.

You can invest in the Nasdaq composite through several index funds. Index funds that track the Nasdaq composite – for instance the Fidelity Nasdaq Composite Index Fund.

The Exchange-Traded Fund (ETF) that tracks the Nasdaq 100. Is the QQQQ, formerly known as the QQQ.

Wilshire 5000 Index

While it may seem as if the S&P 500 and Nasdaq Composite Index includes a lot of companies, you’ll find the Wilshire 5000 Total Market Index contains even more.

The Wilshire 5000 Index contains over 3,500 stocks, despite what its name suggests, that trade in the U.S. The Wilshire is often referred to as the “total market index” by Investors as it was designed to measure the entire U.S. stock market.

Wilshire 5000 Details

  • Index Created By – Wilshire Associates in 1980.
  • Number of Companies in index – 3,000 ~ 5,000
  • Types of Companies in Index – All U.S. equity securities with readily available price data.
  • Index Selection Criteria – Primary equity issues for U.S. companies that are trading on a U.S. exchange with prices readily available. The following are excluded
    • Bulletin board
    • ADRs
    • Preferred
    • Mutual funds

The Wilshire Total Market Index is market-capitalization weighted.

Wilshire Total Market Index Advantages

The Wilshire Total Market Index covers virtually all of the public companies in the U.S.

Wilshire Total Market Index Disadvantages

The Wilshire only contains companies headquartered in the U.S. This leaves out many foreign companies.

The Wilshire Total Market Index is also similar to the S&P 500 in that the top 10% of the companies in the index account for over 75% or so of the index's value.

You can buy mutual funds and ETFs that represent this index to invest in it.

The Russell 2000 Index

We just looked at four market indexes that are all based on the top companies in the U.S., most of them worth billions of dollars.

The Russell 2000 measures the performance of smaller stocks that are often excluded from the bigger market indexes.

The average market capitalization in the Russell 2000 is approximately $530 million. Contrast that with Microsoft which alone has a market capitalization of more than $248 billion.

Russell 2000 Index Details

  • Index Created By – The Frank Russell Company in 1984
  • Number of Companies In Index – +/-2,000
  • Types of Companies In Index – Small cap companies from various industries. Stocks under $1 and pink sheets are excluded
  • Index Selection Criteria – This index consists of the smallest 2,000 companies in the Russell 3000 index.

The Russell 2000 is weighted on market capitalization.

Russell 2000 Advantages

The Russell 2000 Index is a well-diversified index of small-cap stocks focused on non-industry-leading companies.

Russell 2000 Disadvantages

The Russell 2000 Index can be more volatile than large-cap market indexes.

When small caps come and curry favor with investors, the Russell 2000 performs very well. But be careful – the index can remain lackluster for years when small caps are languishing.

There are many index funds that track the Russell 2000 and you can use then to invest in the index.

So far we have looked at most of the big U.S. market indexes, but we've barely scratched the surface of all the other market indexes that exist in the world.

There are literally thousands of indexes tracking nearly any market. We focused on the overall market in this how-to this tutorial but the term “market” can also refer to industry sectors or regions around the world.

Indexes In Other Countries

All major countries have an index that represents their stock exchange.

Here is a list of some of the more important market indexes from around the world:

  • FTSE 100 – United Kingdom
  • Hang Seng – Hong Kong
  • Nikkei – Japan
  • DAX – Germany
  • S&P/TSX Composite Index – Canada
  • CAC 40 – France
  • Standard & Poor's also has a fairly comprehensive list of international indexes.

 

Industries And Indexes

As you may recall the Nasdaq has indexes broken down into the following categories industrial,

  • transportation
  • banks
  • telecommunications
  • insurance
  • computers
  • biotechnology

The Dow Jones industry indexes are virtually unlimited. They maintain over 3,600 indexes overall.

 

Miscellaneous Market Indexes

There are some media publications who have become quite renowned for their specialty indexes.

Perhaps best known specialty index example is the “Fortune 500” by Fortune Magazine. It ranks the biggest U.S. companies by sales.

Yet another notable index comes from Value Line. Value Line is an independent research firm whose research has done extremely well over the long run.

Picking The Correct Index Benchmark

It is important that you use the correct index to measure the performance of your portfolio against even if you don’t invest in indexes

For instance, if you own a mutual fund that invests in the Asian market it would be useless – and frankly pointless- to compare its performance against an index tracking the semiconductor industry.

Market indexes are great tools. They can tell us in what direction the market is heading and the prevailing trends. So how do we buy into these investment vehicles.

For a moment, imagine the costs associated with buying the 6,500+ stocks that make up the Wilshire Total Market Index. The commission fees alone would cost you tens of thousands of dollars.

We have mentioned “index funds” more than once during this how-to. Simply put, index funds are mutual funds that are based on an index and mirror its performance.

There is some academic theory behind index funds. Academics have been holding forth for years that it is impossible to consistently beat the market – without raising your risk level, or frankly being a fortune teller in my opinion.

This is a theory known as Efficient Market Hypothesis (EMH).

This lead John Bogle in 1975 to take the stance of  “if you can't beat 'em, join 'em” and created the first low-cost mutual fund that mirrored the S&P 500 index.

But hold on a second!

Weren’t mutual funds create with the sole purpose of enticing merely mortal investors into enlisting the help of professionals? Professionals whose job it was to achieve superior returns (for a fee of course)?

The mutual fund industry has been trying to sell us that hackneyed story for many years.

The real truth they want you to ignore is that a majority of mutual funds fail to outperform the S&P 500.

Mutual Funds and Index Funds

While the exact stats vary depending on the year on average, anywhere from 50%-80% of funds fail to beat by the market. Whoa nelly! The main reason for this poor performance is attributable to the costs that mutual funds charge.

A fund's real return is the total return of the portfolio minus the fees an investor pays for management and plus fund expenses. If a fund charges 2%, then in order to just break even you have to outperform the market by that amount.

Cue the index fund entrance.

Index funds have as their main advantage lower management fees than you would get from a regular mutual fund.

An average non-index fund has an expense ratio of around 1.5%, whereas many index funds have an expense ratio of around 0.2%!

Wowza!

An index fund is not actively managed and for this reason the costs are lower.

To match the index performance, fund managers only need to maintain the appropriate weightings. This is a technique known as passive management.

The label of “passive” is somewhat deceptive – most funds are actively selected. For example take the S&P 500 – when the index changes, it's very nearly like getting the S&P Index Committee's advice for free.

Of course, Investing in an index fund is not a dead guarantee that you'll never lose money investing. During a bear market investments will go down and they will go up in a bull market.

The return of the S&P 500 historically has been around 10-11%. That’s pretty darn good. It’s key though to hold on for the long term. Get nervous during a downturn and sell the recovery might well pass you over.

Investing in Index Funds Summary

I hope that this how-to has been useful for you. Here are some key takeaways.

  • We defined an index as a statistical measure of the changes in a portfolio of stocks which is seen as representing the overall market.
  • The first index was created by Charles Dow in May 1896. This index evolved into what we know today as the Dow Jones Industrial Average (DJIA).
  • The DJIA uses price-based weighting. This is in contrast to most of the other indexes which use market capitalization based weighting.
  • The DJIA contains 30 of the largest companies in the U.S. Like using Kleenex for “facial tissue” it is what most people are referring to when they talk about “the stock market.”
  • The S&P 500 includes 500 of the largest U.S. companies. Overtime the S&P 500 come to be seen as the benchmark of the U.S. stock market.
  • The Nasdaq Composite Index represents all the companies on the Nasdaq. More volatile than other market indexes it is heavy with tech companies
  • The Wilshire 5000 Total Market Index contains more than 6,500 stocks and is the largest index in the U.S.
  • Measuring the performance of small caps the Russell 2000 tracks those companies that often get left out of the other big indexes.
  • There are literally thousands of other indexes, tracking various regions and industries and there are indexes for all markets in the world
  • Most mutual funds (50-80%) don't beat the market.
  • Investors get the market return from Index funds in part because of their lower expense ratios compared to other mutual funds

 

 

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