What is an Index?

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Ensuring consistently clear and accurate communication with the public is an enduring challenge of our profession.  It’s a complication that can be exacerbated over time as we become more accustomed to using industry jargon with which the general population may be less familiar.  A common example is the use of the generic word “market” when describing what occurs within what could be any number of actual markets where securities are traded.  The intent of this article is to shed some light on what “market” means to most advisors and explain in greater detail the indexes at the source of the appellation.

Readers may be surprised to discover that when most investment professionals say, “The market is up (or down) today,” they aren’t talking about a market at all, but, rather, an index that represents the performance of a collections of securities trading on a market.  So, first, let’s define a market in the purest sense of the word.

In the United States, most securities trade on three major stock exchanges. These are the New York Stock Exchange (NYSE), the National Association of Securities Dealers Automated Quotation System (Nasdaq), and the American Stock Exchange (AMEX).  Whenever you buy or sell a stock in your brokerage account, most likely, the trade is occurring within one of these markets.

However, when it comes to deriving useful information about the movement of stock prices, to reference any one of these three markets can cloud the water a bit as each covers a massive swath of the economic landscape due to the sheer volume of companies listed.  In other words, most advisors want more specific information about certain components of the markets, and this is where indexes come in very handy.

There are dozens of indexes available for examination and research, each representing different segments of the securities marketplace.  These range from stocks and bonds to currencies and cattle.  Whatever sector you’re interested in evaluating, there is probably an index tracking it; and that is the key word: “Tracking.”  Each index is merely an ongoing representation, or tracking, of how the securities which comprise it are performing from one point in time to another.

Before we turn our attention to the major U.S. indexes, I’ll pause to clarify a popular misconception surrounding the subject:  An investor cannot actually “buy” a particular index.  That is, to say, “I am investing in the Wilshire 5000 Index,” is a misnomer as one cannot invest in the index itself.  What the statement may mean is that they have purchased shares of any number of mutual or exchange traded funds that attempt to mimic the performance of the index … now you know.  So, what is an index?

Like the three markets mentioned, there are also three indexes in the United States that seem to get far more attention than the rest, though they are certainly not the largest when it comes to the number of securities represented by each.  These are the Dow Jones Industrial Average, The S&P 500 Index, and the Nasdaq Composite Index.  Whenever you hear a news commentator giving a “market” update (see how easy it is to slip that misidentification in there?), almost universally, they are referring to one or more of these three indexes.

If you are an avid index-watcher, over time, you’ll also notice all three often move in the same general direction.  On most days, when one is way up or down, the others will reflect the same.  The reason, as you will see, is the is substantial overlap of the securities represented on each.   The key differences between them are the number of stocks tracked and the method by which they do so.  Let’s take a closer look at these distinctions.

The Dow Jones Industrial Average (DJIA), or “Dow” in industry parlance, is comprised of only 30 companies.  First introduced in 1896, this is the oldest and perhaps most well-recognized index in the world.  It is intended to represent some of the largest companies in America with minimal overlap amongst industries.  This cross-sector coverage makes the Dow useful in that it gives us a glimpse into the overall health of the US economy.  The one obvious detractor is that it only represents the largest companies in each sector, neglecting what could be hundreds of smaller competitors, any of which may be in much better fiscal health than their larger brethren.

The Dow is what is known as a “price-weighted” index.  That means the index value is determined by adding up the price of one share of each member company’s stock and then dividing the sum by the number of companies represented; for the Dow, that number is 30.  The nice thing about this calculation method is its inherent simplicity.  The problem is that companies with lower share prices may experience substantial gains or losses in market value without that movement being similarly reflected on the index value.  For example, a $5 drop in the share price of the Dow component, Boeing (currently trading at around $208), would mean a 2.4% loss for Boeing stock, while a $5 drop in General Electric (currently trading around $27) would be an 18% loss for GE … ouch!  Yet, both scenarios effect the value of the DJIA in exactly the same degree.  For this reason, and due to the small number of (only large) companies represented, the Dow is not an ideal representation of the US economy as a whole.

Next, is the S&P 500 Index. For most advisors, when we say, “the market,” the S&P 500 is what we are referring to as it is the most common benchmark against which the performance of domestic stock portfolios is measured.  Remember that point, because it is an important footnote in your Glossary of Investing Shorthand. 

As the name implies, it represents 500 companies, most of which are also fairly large, and all based within the United States.  Compared to the Dow, the S&P 500, which represents about 80% of the U.S. market, can give us a much more accurate depiction of the overall health of corporate America.  It includes all 30 DJIA stocks and, obviously, about 470 more.

The value of the S&P 500 Index is determined by using a “capitalization-weighted” (or, “cap-weighted”) calculation method whereby companies with a greater total value of outstanding shares (or “market capitalization”) will have a greater influence on the index value as their share prices fluctuate.  Many believe this approach is preferable to the price-weighting method used by the Dow since larger companies usually have a much larger investor base, thus more accurately reflecting the experience of the typical investor’s portfolio.  To look at this from a slightly different angle, consider this:  With cap-weighting, a fixed percentage drop in all securities represented by the index would lower the index value by the same amount.  This would not necessarily be true of a price-weighted calculation, as described above.

There is, what I consider to be, one enormous flaw in the cap-weighting method, and we are experiencing the manifestation of this problem as more and more “mega-cap” companies begin to dominate the indexes.  Today, the market capitalization of the 60 largest companies in the S&P 500 is greater than the remaining 440 combined!  In practical terms, this means that a bad trading day for just a few of these mega-cap companies could potentially negate a phenomenal day for hundreds of smaller companies, at least, as far as the index value is concerned.

Lastly, we have the Nasdaq Composite Index, most often referred to simply as “the Nasdaq.”  If we could get as close as possible to “market” and “index” being synonymous, this one would take the cake because it represents all the (roughly) 3000 stocks traded on the Nasdaq exchange.  Like the S&P 500, it also utilizes a cap-weighting calculation method.  However, unlike the Dow and the S&P 500, it does include some companies headquartered outside of the U.S.  Many consider the Nasdaq to be a “technology index” due to the number of smaller tech companies represented, many of which are too small to find their way to the Dow or S&P 500.  However, the Nasdaq was never intended to be a tech-focused index as just about every sector in the economy is also present simply by virtue of trading on the Nasdaq exchange.

And there you have it!  Armed with this information, the next time you hear someone say, “The market is doing well this year,” you can flex your investing prowess by asking, “To which index are you referring when you say that?”

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