If you read or listen to the financial media, you might get the impression that the Dow Jones Industrial Average, usually referred to as the Dow, represents the pulse of the market. Other stock indexes like the S&P 500 or the Nasdaq Composite also get mentioned more or less often, depending on their numbers.
These and other reported indexes can give you a good amount of information and insight to use in making more informed investing decisions.
Explaining Index Numbers
First, take a look at what an index number represents. Although there are different ways to calculate index numbers, the numbers always represent a change from an original or base value. The base value represents the weighted-average stock price of all the stocks that make up the index.
The index number has much less importance or meaning than its percent change over time. This movement up or down gives you an idea of how the index is performing. Is the Dow up or down? The index gets calculated on an ongoing basis each day during the stock market’s open hours, to give investors a sense of direction for the market the index represents.
Be aware, though, that most stock indexes, even those quoted as representing the total stock market, only reflect a portion of the actual market. This happens because each index typically holds stocks from certain sectors or categories of the market.
Reading the Indexes
Keep these factors in mind when analyzing and interpreting changes in a given index:
- Indexes don’t represent the total market. No matter what happens with the big three indexes, stay focused on your stocks or targets for evaluation. Pick any day that all three indexes are down, and you will still see some stocks setting new highs that same day.
- Indexes react to actual trades. If you listen to some of the financial news commentators, you might think the indexes move on emotion. Investors may want to trade on the expectation of good or bad news, but index movements require actual trades, not just investor feelings.
- Focusing on day by day, hour by hour, minute by minute clicks of an index makes for a good way to eat up valuable time.
- Indexes provide a better historical perspective, rather than a forecasting vehicle. They can be especially helpful when viewed over a long historical period when researching trends.
The Major Indexes
The following summarizes the most popular indexes and the market sectors they capture:
The Dow Jones Industrial Average (DJIA)
The Dow Jones Industrial Average is the oldest and most widely known index. It is also the most widely quoted index and often, whether right or wrong, considered the market barometer.
Originally, it was a simple average of the stock prices in the index, but thanks to stock splits, spin-offs, and other transactions, the index now requires a more sophisticated price-averaging calculation. The Dow currently holds 30 stocks.1 However, these stocks represent some of the largest and most influential companies in the U.S.
The Dow is the only major index that is price-weighted, which means if a stock’s price changes by $1, it has the same effect on the index regardless of the percent change for the stock. In other words, a $1 change for a $30 stock has the same effect as a $1 change for a $60 stock.
The calculation of the Dow takes into account numerous stock splits over the years. By adjusting the math, it is possible to keep a historically viable index meaningful.
The Dow stocks represent about one-quarter of the value of the total market, so in that sense, it is a telling factor and big changes can indicate investor confidence in stocks, however, it does not represent investor sentiment regarding any small or mid-size companies.
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