Stocks and Bonds

What is the stock market index – and why is it helpful to understand?

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Debra Ohstrom, CFA is an online course creator who uses her financial expertise to empower women to take control of their financial future.

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The 3 most talked about indices

I know we all often hear news reports with price quotes or comments that the Stock Market is up or down by a certain % or number of points on any given day. There are usually 3 main indexes that get talked about in the news so I want to explain them here. Also, there are other indexes in existence representing both the bond and stock market that I will also explain as well as how people can invest in them or in portfolios that are similar to what they represent.

The Dow Jones Industrial Average, The S&P 500 Index and the NASDAQ

So what is the stock market index when you hear that talked about on the news or online? Articles and news reports are usually referring to the Dow Jones Industrial Average or the S&P500 Index as a broad representation of the stock market in general. First, lets talk about the Dow Jones Index. Currently, there are 30 companies that are chosen to be included in this index and they are large companies that are leaders in their industry such as Microsoft, Apple, McDonalds, Visa and JP Morgan Chase just to name a few. Each company has a different weight in the index so that means each company’s increase or decrease in daily price can have a different impact on the daily change of the Dow Jones Industrial Average change. Now let’s talk about the S&P500 index. As the name states, there are 500 large companies included. These companies are chosen as a broad cross section of the US stock market that are financially healthy. The weight of a company in the S&P500 index is based on the size of the company so if the largest company has a stock price change this will impact the change in the index more heavily. Finally, we can discuss the NASDAQ index. The NASDAQ index tracks the price changes of the roughly 4000 companies that are listed on that exchange. Many of the companies are in the Technology and Biotech sector so it can be viewed as representative of that area of the market place.

Many more indices exist to help investors

Many other indexes currently exist and are used to get a general sense of how a certain segment of the stock market is performing. There are roughly 10,000 publicly traded stocks so putting them into categories based on size or sector can help investors better understand what areas of the stock market are performing better or worse than others. For example, a company called FTSE Russell has created many indexes based on size like the Russell 2000 for small companies or the Russell 1000 for large companies. MSCI has created country indexes such as EAFE index which is designed to represent 21 different developed countries around the world. The S&P has also created sector indices such as the 11 sectors in the S&P500 index. Each sector of the US market has its own index which can be tracked such as Healthcare, Consumer Staples or Technology to name a few. Lastly, I will mention that in addition to stock market indexes there are also bond market indexes to track the broad fixed income market like the US Barclays Aggregate Index. All of these indexes make it easier to track performance of different areas of the overall US market place and help investors get a sense of what is performing well and what is not.

How often do indexes change and what companies get included?

All of these indexes have different rules to how often they make changes and to which companies will be included. The S&P500; Indices and the DJIA are both more subjective in nature though they consider financial profitability and stability as well as size of a company as factors to consider. This means that some high-profile companies that may not yet have consistent earnings will not be included. These are companies like Tesla where earnings may not yet be positive though their stock price has risen substantially.

Some other indexes like the Russell 2000 are designed in a more clear cut manner. Once a year the Russell Indexes will recalculate the companies to be included based on the size of the company and a few other factors.

As you can see Indexes were created to give investors a breakdown of the marketplace and help them understand how the broad market overall is performing or even different segments that could be driving those returns.

Passive vs Active Investing

These indexes can be invested in through ETFs (Exchange Traded Funds) or through MF’s (Mutual Funds) and we will go into more detail on these investment structures in the future but first I wanted to make sure you know the difference between the terms passive investing and active investing.

Passive investing is when a portfolio mimics what is owned in a specific index like we have just discussed above. This allows investors a clear cut way of knowing the stocks owned or what segment of the market they will be investing in. For some indexes like many of the Russell Indexes, since the companies only change annually and its controlled by the FTSE Russell Index company it is clear cut and easy to implement by Mutual Fund and ETF companies. This simplicity keeps costs low for investors.

Active Investing is when an ETF or Mutual Fund is managed by a paid portfolio manager and their goal is to outperform an index that is similar to the area of the market they are focused on. For example, some Mutual Funds may have an active large company mutual fund where a portfolio manager is picking 60 to 100 stocks to own in a portfolio based on their company’s research. The portfolio manager is looking to perform better than the index by doing financial analysis on the companies and making a decision to own shares in that company or not based on their view of the company’s ability to make profits in the future. This analysis is more work by a portfolio manager and a team of research analysts so the cost to invest in that ETF or MF is usually higher than the specific Index ETF or MF. There is an ongoing debate in the industry if the cost of active investing is worth it since many times over the past few years passive investing has performed better than the portfolio managers.

The importance of indexes

As you move along your journey of learning about investing, understanding indexes is a key part since many portfolios now use them as ways to invest in different areas of the stock and bond market. Understanding them and the segment they target will allow you to combine these strategies in a way that will best fit your goals.

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Debra Ohstrom, CFA is an online course creator who uses her financial expertise to empower women to take control of their financial future.

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