Understanding Stock Market Indexes

Jane Young, CFP, EA

Jane Young, CFP, EA

A stock market index provides a benchmark from which you can measure the performance of the stock portion of your portfolio.  An index statistically tracks the movement of a specific grouping of stocks.  There are numerous indexes that range from monitoring performance of the entire market to specific sectors of the market.  When referencing an index it’s important to understand what comprises the index and how the stocks are weighted.

The oldest and most widely followed index is the Dow Jones Industrial Average (DJIA), founded on May 26, 1896 by Charles Dow.  It is comprised of 30 stocks from a wide range of industries with the exception to transportation and utilities.  The 30 stocks comprising the index are selected by editors of the Wall Street Journal with the goal to show a true reflection of the market by focusing on relevance, longevity and market representation.

The DJIA isn’t actually an index but a price weighted average where more expensive stocks represent a higher proportion of the index and have more influence on the movement of the index than lower priced stock.  Originally, the DJIA was an average of the sum of the prices on all stocks in the index divided by the total number of stocks.  However, over time the calculation has been adjusted to account for stock splits and dividends.

Currently the DJIA represents about 25% of the total value of the U.S. stock market.  Although it only represents 30 widely known companies, over the long term it tracks well with the S&P 500 and can be a good measure of large company stock performance.

The S&P 500, another widely known index, was created on March 4, 1957 by Standard and Poor’s and is now part of McGraw Hill Financial.  It is comprised of 500 U.S. companies chosen by a committee at Standard and Poor’s with an objective to represent the U.S. stock market based on “market size, liquidity and group representation”.  It excludes companies that invest in real estate and companies that primarily hold stock in other companies.  Currently the index is solely comprised of U.S. companies, primarily but not limited to large companies.  The S&P represents about 75% of the value of the U.S. Stock Market, providing a much broader picture than the DJIA.

The S&P 500 is a market-cap weighted index where the weight in the index is based on the total value of all outstanding stock in the company.  As a result, large companies have much greater influence on movement in the index than do small companies.  About 50 of the 500 stocks in the index represent half of the total market capitalization within the index.

There are numerous other indexes available to monitor performance on specific sectors, smaller company stock and international stock.  For example, the Wilshire 5000 Index is a total U.S.  market index covering almost all publicly traded U.S. companies and the Russell 2000 Index covers the 2000 smallest publicly traded U.S. companies – both of which are capitalization weighted.