What you will learn
- Explain how one stock index can summarize a large part of the market
- Compare the S&P 500, Dow, and Nasdaq Composite
- Explain how an index's weighting method changes the result
- Describe how investors get index exposure without buying the index itself
When a news report says the market rose today, it usually means an index went up. An index combines the performance of a group of stocks into one number. That saves you from checking hundreds of companies one at a time. Three US indices appear often in market news, and each one builds its number differently.
What is an index? The Dow, S&P 500, and Nasdaq explained
Finance and Quant Society introduces all three indices. Nice introduction to what indexes are and how they work!
Three major US indices
- The S&P 500 tracks about 500 of the largest US companies. Most professionals use it as the main benchmark for US stocks.
- The Dow Jones Industrial Average follows only 30 large, well known US companies. It is the oldest and best known of the three, but its design has an unusual feature.
- The Nasdaq Composite covers all the companies listed on the Nasdaq exchange, which number in the thousands. Technology companies make up a large part of it.
Key terms
- Index
- One number that follows the combined performance of a group of securities.
- Benchmark
- A standard used for comparison. The S&P 500 is a common benchmark for US stocks.
- Market-cap weighted
- A method that gives more influence to companies with a larger market value. The S&P 500 uses it.
- Price-weighted
- A method that gives more influence to stocks with higher share prices, no matter how large the companies are. The Dow uses it.
How much does each company count?
Every index needs a rule for deciding how much influence each company gets. That rule is called weighting. In a market-cap weighted index such as the S&P 500, companies with greater total market value move the index more. The Dow is price-weighted instead, so a stock with a higher share price gets more influence even if its company is smaller. The example below shows how the two rules can point in opposite directions.
The same two companies, weighted two ways
Company X is small but trades at $300 per share. Company Y trades at $30 per share and has ten times the market value. Which company has more influence under each weighting method?
- Use price weighting, as the Dow does. Share price is the only factor. Company X at $300 gets ten times the influence of Company Y at $30, even though X is the smaller company.
- Use market-cap weighting, as the S&P 500 does. Total market value is what counts. Company Y is ten times larger, so it gets far more influence than Company X.
Why it matters: A $500 stock can move the Dow more than a much larger company with a lower share price. Because of that price-weighting quirk, the S&P 500 gives a better picture of the overall market.
| Index | Companies included | Weighting | Useful as |
|---|---|---|---|
| S&P 500 | About 500 large companies | Market-cap weighted | A broad view of the US market |
| Dow Jones | 30 large companies | Price-weighted | A famous but narrow market measure |
| Nasdaq Composite | Thousands of Nasdaq-listed companies | Market-cap weighted | A view weighted heavily toward technology |
Pick a broad US benchmark
A friend wants one number that gives a broad, balanced picture of how large US companies performed today. Which index would you choose?
The S&P 500 is the standard broad benchmark. It includes about 500 companies and weights them by market value.Tell the indices apart
Match each index with the feature that sets it apart.
An index is a measuring tool. The S&P 500 weights company size, while the Dow weights share price. Neither covers the entire market.
How investors follow an index
An index is a calculation, so you cannot own the S&P 500 itself. You can buy a fund, often an index ETF, that holds the same stocks and tries to follow the index closely. This is how most people get broad, low cost market exposure in one purchase. The idea will matter again when you study diversification.
Stock indices and index fund investing (The Plain Bagel)
Index funds turn an index into something investors can buy. Notice why holding the full group can be a low cost strategy.
Why the S&P 500 is broader
Explain why the S&P 500 gives a more balanced picture of the US market than the Dow. Include the number of companies in each and the way each index is weighted.
Write an answer before comparing it with the model response.
Model answer
The S&P 500 includes about 500 companies, compared with only 30 in the Dow. It also weights each company by market value, so larger companies count more. The Dow weights by share price, which lets a smaller company with a high share price move the index more than a larger company with a lower share price.
Indices give you a quick way to describe a large part of the market. The next lesson looks at the longer rises and falls behind the terms bull market and bear market.