Anyone with even a passing interest in the stock market has heard of the Dow, or the Nasdaq (index not the exchange), or the S&P 500, but what are these indices, and how can they be used to understand the economic market?
What an index does
To begin, it’s important to understand what an index really is. An index is a diagnostic tool to measure the activity of the market. There are thousands of companies traded in the New York Stock Exchange (NYSE), and even more companies to consider when you add in the Amercian Stock Exchange (AMEX). The number of companies, and the number of shares make it necessary for there to be an index to track the changes in those markets.
The index takes a sampling of those companies, and the trading activity for those companies, which creates a sort of snapshot of the health of the market. There are different methods for the calculation, some indices give more weight to trading activity of companies based on their size, while other indices give more weight to companies based on the price of their shares.
By looking at the index, you can get an understanding of the activity of the market overall. That is to say, if the index is up, it’s fair to say that the market that index represents is up as well. The truth is an index is not a perfect understanding of individual companies, but it is a good tool for understanding the market as a whole. With that in mind, let’s take a closer look at the three most common indices in the United States.
The Dow Jones Industrial Average
The Dow Jones Industrial Average (Dow) is the oldest index in the United States, and as a result is the best known and most followed index. Comprised of 30 companies that have a market capitalization value of over $10 billion dollars, the Dow is also used to predict the economic health of the nation. The companies in the Dow are largely household names, things such as Coca-Cola, General Electric, and The Home Depot. By tracking the performance of these large-cap companies, the index provides a snapshot of the US market as a whole.
The only thing to be aware of about the Dow, is that the index is price-weighted. That means that companies with a higher share price have a larger affect on the Dow’s movement. For instance, Visa, which trades at a higher price, has a larger impact on the average than the Coke, which has a lower share price.
The Nasdaq adds a layer of confusion by being not only a market (primarily for technology stocks) but by also being an index. When talking about the index, it’s the Nasdaq composite that is being discussed. The Nasdaq composite tracks many more stocks than the Dow, with the 4000+ stocks in the market being included in the index. Unlike the Dow, the Nasdaq is weighted by market cap, meaning companies with the highest market value have the most affect on the price. Even though there are some companies outside the tech industry that trade in the Nasdaq, the composite is still a good indicator of the performance of technology stocks.
The Standard & Poor’s 500
The Standard & Poor’s 500 (S&P) differs from the Nasdaq and the Dow in several ways. To begin, the criteria that the S&P uses to include companies in the index is different. To be included in the index, a company must have market cap of more than $6.1 billion USD and a minimum monthly trading volume of 250,000 shares in each of the six months leading up to the evaluation date, and at least 50% of the stock must be in the public float. Because the S&P has such strict requirements to be included in the index, it’s often considered the best measure of the market, and the US economy.