Understanding Market Indices for Beginners

November 23, 2020
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Donny Raw
Posted in Finance
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An index is an indicator or measure of something. When applied to finance, it mainly refers to a measure of a movement or change in a security’s price. Forstocks and bonds, indices consist of a hypothetical portfolio of securities that represent a particular market of a portion of it.

Indices Methodologies

Each individual index sports its own method for calculating the overall value of the index. The primary basis of index calculations is the “weighted average mathematics.”

And because of that, indices that use price weightings are more greatly impacted by changes in the holdings with the highest prices. Meanwhile, indices that are weighted by market cap will move depending on the changes in the largest stocks.

Using Indices as Benchmarks

Indices mainly serve as benchmark comparisons for a plethora of purposes on the broader financial markets.

Over in the United States, the most popular indices are the S&P 500, NASDAQ Composite, and the Dow Jones Industrial Average.

Each of them holds different kinds of stocks. The Dow holds 30 of the largest stocks, while S&P 500 holds 500 of them. The NASDAQ is mainly associated with technology stocks.

And because they include the biggest stocks in the US, traders use them as benchmark for the overall performance of the US stock market.

The S&P 500

The S&P 500 is an index that has 500 of the biggest stocks in the US. It is a market or capitalization-weighted index.

That means every stock in this index is represented in proportion to its total market cap. For instance, if the total market value of all the companies in the index slips by 5%, then the value of the whole index also drops 5%.

The constituent committee considers factors like liquidity, financial viability, trading history, sector classification, and public float when they choose which stocks can go on the index.

The Dow Jones Industrial Average

The Dow is among the most popular and oldest US indices. This index tracks only 30 of the biggest companies in the US.

It is a price-weighted index that has a pretty complicated process of calculations. Because of stock splits, spin offs, and other events, changes in the divisor have happened.

Any change in the Dow means a change in the investors’ expectations of the earnings and risks of the large companies that are included in the index.

But keep in mind that investors generally have a different attitude toward large-cap stocks compared to small-cap ones. As a result, you shouldn’t use the Dow as a representation of the sentiment in other areas of the marketplace.

The NASDAQ Composite

The NASDAQ Composite Index is primarily associated with the biggest technology stocks. This is a market-capitalization-weighted index of all the stocks traded on the NASDAQ exchange. One defining feature of this index is that it includes stocks not based in the US.

The NASDAQ index includes subsectors across the tech sectors like biotech, semiconductors, software, and many more.

But the index is not exclusively for tech stocks. You can also find other sectors like insurance, transportation, financials, and industrials.