Market indexes explained

The stock market is made up of many indexes

As the saying goes, “there are many ways to skin a cat.” And when it comes to investing, there are countless methods one could follow to measure the stock market. After all, the “stock market” is actually a series of markets, and consists of thousands of companies both in the US and globally, which have publicly listed shares on exchanges such as the New York Stock Exchange (NYSE) and the NASDAQ. Bond markets also have different indexes that investors use to gauge returns of individual bonds and bond funds.

Mutual funds and ETFs often invest based on an index

For most investors, major indexes such as the S&P 500, Dow Jones Industrial Average (DJIA), and the NASDAQ Composite provide a reference point on how the overall stock market is doing. There are also many mutual funds and exchange-traded funds (ETFs) that invest with the intention of tracking (mirroring) the returns of these indexes.

The S&P 500 is made up of the 500 largest US companies by market cap

Each market index differs in how it’s constructed, what it measures, and therefore what it purports to tell us. For instance, the S&P 500 consists of the 500 largest US companies by market cap. These stocks each have a weight within the index that corresponds to its market capitalization, i.e., its market value. This means that a stock with a very large market capitalization, such as Apple or Amazon, will have an outsized influence on the overall index.

We often refer to the S&P 500 as a “large cap” index. This means that it tracks the stocks of very large companies. In contrast, there are also different indexes that track “mid-cap” and “small-cap” stocks.

The Dow Jones Industrial Average is a unique market index

The Dow Jones Industrial Average, or “the Dow” for short, tracks 30 large US companies across most industries. These stocks are selected by a committee and can change over time.

One criticism of the Dow is that, unlike the S&P 500 and other indexes which are market cap weighted as discussed above, the Dow is weighted by share price. This means that those stocks with a higher share price can have a more significant impact on the overall index than those with lower share prices. Some investors find less meaning in this index because, to these investors, the total market value of a company may be most important. Since the total number of shares can differ significantly and arbitrarily across companies, comparing share prices across companies is like comparing apples to oranges. Additionally, this index only follows 30 companies and an index that includes a larger number of companies may be a better reference point for the market overall

The NASDAQ Composite is known for being tech-heavy

The NASDAQ Composite is an index of the companies listed on the NASDAQ exchange. Traditionally, these stocks have leaned toward the Information Technology sector. For instance, the NASDAQ was a key index to watch during the tech boom of the 1990s. There are also many mid-cap or growth stocks that are listed on the NASDAQ. Therefore, if your interested in how the tech sector is doing overall, this is a good index to watch.

Being knowledgeable can help you reach your goals

There are many indexes to be aware of when watching and investing in the overall stock market. It’s essential to understand what each one measures and how they are different. Knowing how the returns of these indexes relate to your investments can give you context to how your portfolio is performing.For example, if you are in a fully diversified portfolio across stocks and bonds — which includes investments from different regions and sectors — just comparing your returns to the S&P 500 may not make sense. Being knowledgeable can help you choose which mutual funds and ETFs to consider to reach your goals.