You may hear on the nightly news “The Dow was down 1.3% today” or “The NASDAQ was up 50 points today.” Have you ever wondered what they were talking about or what it meant? You are not alone in those thoughts.
A stock market index is a quick way to find out how the stock market is doing as a whole. There are many different types of indices. Some measure only large companies, some only small companies. Some measure only specific industries. And others only measure specific countries or regions of the world. Let’s get into some details.
What is the difference between market-weighted, price-weighted, and equal-weighted indexes?
There are three ways the stock market index can be calculated: The first is by using a market-weighted calculation. This means companies with a higher market cap (total valuation of a company) hold more weight than those with a lower market cap. For example, an index that contains Amazon and Dollar General will put more weight on price changes for Amazon than Dollar General. This is because Amazon’s market cap is about 25x greater than Dollar General.
The second is by using a price-weighted index. A price-weighted index means that a stock with a higher price will have more weight than a lower price stock. Using our previous example, Amazon would have a higher weight than Dollar General because Amazon’s stock price is about 14x higher than that of Dollar General. A $10 increase in Amazon’s price will have a higher impact on the index than a $5 increase in Dollar General, even though the increase with Dollar General will have a greater percentage increase on the value of Dollar General.
Finally, there is something called an equal-weighted index. An equal-weighted index means all changes in individual stocks have an equal impact on which direction the index moves. Rather than a change in price, this will use a return percentage as its main calculation. If Amazon and Dollar General are the two stocks in our index, and AMZN is up 10% and DG is down -15%, then the index is down -2.5%.
What are the different index names people usually reference?
The S&P 500 measures the 500 largest companies in the United States based on market cap size. The stocks inside it comprise a wide variety of industries and the index is widely considered to be the best representation of the United States stock market and economy. It uses a market cap weighted calculation method.
The Dow 30, also known as the Dow Jones Industrial Average, is one of the oldest market indices in the US. It measures 30 of the largest companies in the US. You’ll often hear news organizations reference the Dow over the S&P 500. It is a price-weighted index.
The Nasdaq Composite index is one of the newer, and most influential, indices in the US. It comprises of stocks listed on the NASDAQ stock market. These companies are typically more Technology industry oriented and there are over 3000 companies that make up the index. These companies do not need to be headquartered in the US to be listed. It is a market cap weighted index.
The Wilshire 5000 Total Market Index measures almost all stocks actively traded in the US. One would assume there are 5000 stocks in the index, but the actual number is closer to 3,500. It is considered to be the most thorough index to value the US stock market. While mainly a market cap weighted index, there are subset versions of the index that use equal weight calculations as well.
What are some other popular indices?
Here are some other popular indices with links to additional information.
Why Is This Important?
Knowing how the stock market or sections of the stock market are performing is an important step in the financial planning and wealth building process. Without knowing how the market is doing, it is hard to measure how your own investments are performing. If the S&P 500 is up 20% for the year and your investments are only 10%, that may not be in line with what you are willing to take on for your risk tolerance. Likewise, if the S&P 500 is down -30% for the year and your investments are only down -10% for the year, instead of fussing at your financial advisor you should be giving them a hug!
Have the knowledge of how the stock market is performing is a like compass for your own investments. You wouldn’t go on a road trip without some sort of navigation because there is a good chance you’ll get lost along the way. It’s no different from your investments. Start paying attention to how some indices are performing now and over time and you’ll be amazed at how much you’ll learn in the process. And if you need help getting pointed in the right direction, then Melby Wealth can help with that too.
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