The Dow is up and the NASDAQ is down, but the S&P is unchanged. These terms get tossed around by everyone, from television pundits to politicians to people on the street. Many people assume they are representative of the stock market as a whole, while others think they represent the state of the economy. Understanding what these terms mean and what they refer to is as essential for anyone who’s interested in actively investing in stocks or who’s saving for retirement. Consult with a financial advisor if you have questions about how stock indexes can affect your investments.
What Is a Stock Index?
A stock index is one of the most important tools at any investor’s disposal. They allow you to track the performance of the market at large, which can provide invaluable insights. What they essentially are are baskets of stocks, which are usually related to one another. For instance, a stock index may track the healthcare industry or agriculture.
Some stock indexes are used purely to analyze the market and make decisions. In this context, active traders, advanced investors and investment firms will take advantage of indices.
On the other hand, the typical investor will use a stock market index to attain reliable, long-term returns. In fact, from 1929 to 2018, the average annual return from the S&P 500 varies mostly between 10% and 11%. That type of growth far outpaces inflation, making it a viable long-term strategy.
Understanding the Dow Jones
The full name of this most commonly referenced index is the Dow Jones Industrial Average, or the DJIA for short. The Dow Jones measures the performance of 30 significant stocks, which are primarily traded on the New York Stock Exchange (NYSE), along with a few from the Nasdaq.
The companies that make up the DJIA come from different segments of the economy, from tech to retail to pharmaceuticals, and the list includes recognizable names like Microsoft, Disney and Walmart.
The Dow Jones has the distinction of not only being the most watched and quoted stock index, but also the oldest. It was created in 1896 by Charles Dow as a way to get investors interested in purchasing stocks. The DJIA, which is the most widely quoted financial indicator, uses a price weighted index to determine its performance.
The Dow’s value is calculated by adding the prices of all the stocks in the index and dividing by the total number of stocks. Stocks that have a higher price are given more weight and have a greater impact on the index than those with a lower price.
What Is the Nasdaq?
The Nasdaq composite is a measure of the performance of all the stocks that trade on the Nasdaq exchange, which was created, in 1971, as a way for investors to buy and sell the stocks of companies that come from the technology and biotech business sectors.
There are currently about 3,100 stocks that are traded on the exchange, and they range from Apple to American Airlines to Whole Foods. There are two indices that track this exchange: the Nasdaq composite, which measures the performance of all the stocks traded on the exchange, and the Nasdaq 100, which is comprised of the 100 largest non-financial companies on the exchange.
The Nasdaq composite is by far the more commonly cited of the two indices, and its value is determined using a capitalization-weighted index. Unlike the DJIA, which uses stock prices to weight the importance of stocks, the Nasdaq composite uses market capitalization to weight the importance of each.
It is computed by adding up the market capitalization of all the stocks on the exchange and dividing it by the number of companies. While the Dow is a reflection of the investor confidence in stocks, the Nasdaq is a reflection of how larger companies are performing.
How the S&P 500 Works
Like the Dow Jones and the Nasdaq composite, the S&P 500 is an index of stocks. The S&P is considered by many investors to be the most accurate representation of how the overall stock market is performing, as it uses 500 stocks chosen based on size, industry and other factors to reflect a wide swath of industries. The stocks are selected by a committee of analysts and economists from Standard and Poor’s, which is a financial services publishing company.
Know the inner workings of stock indices can give you an entirely different view of the stock market as a whole. In fact, it shows exactly how reliable investments can be over time. This is even despite the fact that individual stocks on their own are relatively volatile and risky.
Choosing to focus your investment energy on indices is a bright move by most financial standards. Although you could find stronger returns by choosing individual investments, following indices and other stock market trackers can provide much more reliable returns.
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