People often talk about the Dow Jones when they talk about how the market is doing. The Dow, however, is not the market. It is an index. Not even a very good one but everyone uses the Dow number. There are many indexes each with a different definition. However, few investors know what exactly those terms mean. The topic of this newsletter will be stock market indices.
A stock market index is a group of stocks. Different indexes are weighted differently in regards to their component stocks, and the value of each index is represented by a single number. The four main indices that Americans look at are the Dow Jones, the S&P 500, the Nasdaq, and the Russell 2000.
The Dow Jones Industrial Average is a price weighted index composed of 30 prominent industrial stocks. It was created in 1896 and was initially composed of 12 companies. Over time those companies have been replaced by other companies as those original companies have gone out of business or in some way become unfit for inclusion. Price weighted means the value of the index is simply the sum of the prices of each component stock divided by a “Dow Divisor”, which is currently approximately .15189. The index is not necessarily representative of the state of the US economy as it is a very limited number of companies and is only large cap industrial companies.
The Standard and Poor’s 500 is a capitalization-weighted stock market index of the 500 largest companies in the United States. Capitalization-weighted means each company has an equal impact on the index’s value. The price of each company is weighted based on the size of the company. The index was created in 1957, and is highly regarded as a general barometer of the US economy.
The Nasdaq Composite tracks almost all stocks that are listed on the Nasdaq stock exchange, which has a heavy bias towards information technology companies. The index is capitalization-weighted and was founded in 1971. In order for something to be listed on the Nasdaq Composite, it must be exclusively listed on the Nasdaq exchange.
The Russell 2000 index is a small cap index that is composed of the smallest 2000 stocks in the Russell 3000 index. It was founded in 1984 and is capitalization weighted. The Russell 3000 index was an index designed to represent the entire US stock market and currently represents approximately 98% of the US stock market.
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