What is a Market Index?
🤔 Understanding a market index
Market indices are non-tradable baskets of stocks, bonds, or other asset classes that investors use to assess the performance of a given market over time. For example, the S&P 500 is one of the most commonly used market indices – Investors often use it to understand how the US stock market is performing and benchmark how well their investment portfolios are faring. Financial analysts create many types of market indices based on what is most relevant for them – They may create an index for the tech sector or a specific region, like Asia. Each market index has a different methodology for deriving its index value, but generally it is some type of weighted average from the group of securities – It may be weighted by market capitalization, revenue, or stock price. While market indices are not tradable and simply track performance, index funds created by portfolio managers are tradable and designed to mimic a market index as perfectly as possible.
One of the best known examples of a market index is the Dow Jones Industrial Average (DJIA). The Dow is one of the oldest market indices in the world and was established in 1896 by Edward Jones and Charles Dow. The two wanted a simple way to track the performance of a broad swath of the American economy. Today, the DJIA tracks 30 companies across the New York Stock Exchange (NYSE) and NASDAQ, including Apple and Coca-Cola. Many news outlets and financial analysts use the Dow as their default index when discussing the performance of the US stock market – It is usually cited stating the number of points the index gained or lost each day, along with the corresponding percentage change.
A market index is like a thermometer…
Thermometers track the temperature changes in a given area. You can put a thermometer in your home to see how warm it is inside or place it outdoors to find the temperature there. You can also use a thermometer to check your own internal body temperature. Similarly, market indices track the financial performance of a certain group of stocks or bonds. They might include just one industry, a specific geographic region, or depict the global market as a whole.
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- What is a market index?
- What are index funds?
- What are the different market indices?
- How are market indices used as benchmarks?
- How is the value of a market index calculated?
- How do you read market indices?
- Where can I find a list of stock market indices?
What is a market index?
A market index is a non-tradable group of securities, such as stock, bonds, or other asset classes that investors use to gauge the performance of a given market over time – whether that be a single industry, region, exchange, or the global market as a whole.
For example, market indices like the Dow Jones Industrial Average (DJIA) and the S&P 500 track the stock performance of large publicly traded companies in the United States. These two indices are amongst the most commonly used when evaluating the performance of the US stock market overall. Meanwhile, the Russell 2000 tracks the performance of smaller companies in the US.
Investors can and do create their own market indices to examine specific industries most relevant to their investing strategy and needs – They may create an index of technology or manufacturing sector stocks. They may get even more precise and track, say, only the stocks of technology companies in emerging markets.
There are also bond indices, which track the performance of bond investments. One of the most popular is the Bloomberg Barclays US Aggregate Bond Index – This measures the US investment grade (aka reliable) bond market and is used as a proxy for the performance of the US bond market as a whole.
Investors often benchmark their portfolio’s performance against the performance of an index. For example, if their portfolio contains stock shares of small US companies, they may aim to meet or exceed the returns of indices that track “small cap” US companies, like the Russell 2000.
Because there are so many different market indices, it can sometimes be difficult to choose the right index to compare a portfolio’s performance against. Typically, the best choice is an index that closely mirrors the holdings or strategy of the portfolio being compared. For example, someone focusing on technology stocks should compare their performance against an index of technology companies. But a bond investor shouldn’t compare their performance against stock indices if they want an accurate comparison – They’ll want to use a bond index instead.
What are index funds?
An index fund is a type of mutual fund or exchange-traded fund (ETF) that aims to mimic the performance of a specific market index, such as the S&P 500 or the FTSE All-World Index Series. These index funds are built by portfolio managers and are designed to track a market index as perfectly as possible.
Deciding what stocks or bonds to invest in can be a challenge since there are so many options out there. That’s one reason both mutual funds and ETFs were created – to make it easier for investors to diversify their portfolios. Portfolio managers take a bunch of money from individual investors, put it in one big pot, and use the money to invest across dozens or hundreds of securities, often trying to mimic a certain market index. When investors buy a share of a mutual fund or ETF, they are generally gaining exposure to a wide range of investments. Each share of the fund represents a small fraction of the securities that the mutual fund or ETF holds.
Index funds tend to be passively managed, meaning that the fund managers don’t make active decisions about what securities to buy and sell or when to make those transactions. Instead, they aim to replicate a chosen market index’s performance as much as possible (though it’s nearly impossible to perfectly mirror).
For example, if you had an index fund designed to replicate the S&P 500, you would expect it to grow close to 10% in a year if the S&P 500 were up 10% that year. If the S&P 500 were down 20%, that index fund could expect to lose around 20% of its value. The tracking usually isn’t perfect, so a 10% increase in a market index might mean that the index fund increases 9.2% or 10.05% – and so on. Fees also reduce the fund’s actual returns for investors as compared to the market index it tracks.
This investing strategy is in contrast to active investing, where the fund managers try to beat market performance by regularly buying and selling securities based on their beliefs about their future prospects.
The advantage of index funds is that conceptually they’re simple. Investors don’t need to read about a manager’s complex strategies and investing philosophies – They only need to know what index the fund is trying to replicate. Index funds also tend to be much cheaper to invest in due to lower management fees.
Mutual funds usually charge management fees, and the fees are typically a percentage of your assets invested annually. Many ETFs also charge fees, though they are typically lower than those of mutual funds.
What are the different market indices?
There are many different market indices that investors commonly track. Globally, the MSCI EAFE (Europe, Australasia, Far East) index is one of the main indices for international stocks. There are a myriad of others, including the S&P Global 100, Global Dow, and FTSE All-World Index Series.
The Bloomberg Barclays Aggregate Bond Index is one of the most popular indices for the bond market. Others include the Merrill Lynch Global Bond Index, Capital Markets Bond Index, and Citi US Broad Investment-Grade Bond Index (USBIG).
And now we’ll dive more deeply into the three most common stock market indices in the US – the S&P 500, the Dow Jones Industrial Average (DJIA), and the Russell 2000.
The S&P 500 is a market index that measures the stock prices of the 500 largest publicly traded companies in the United States. It’s a popular index for mutual funds to track and is considered one of the best barometers for the financial wellbeing of the American stock market as a whole.
It’s weighted using each company’s market capitalization value, so the most valuable and biggest companies move the index the most.
Dow Jones Industrial Average (DJIA)
The Dow Jones Industrial Average (DJIA) is one of the oldest market indices, founded in 1896. It tracks 30 of the largest, best-known businesses in the United States, including Apple and Coca-Cola. The DJIA is one of the most-frequently cited market indices by news outlets and financial analysts.
The Russell 2000 is an index that captures the stock performance of 2,000 of the smaller publicly traded companies in the US. In many ways, it is similar to the S&P 500 but tracks smaller companies instead of large ones. Like the S&P 500, it is weighted by market capitalization.
How are market indices used as benchmarks?
Market indices are used as benchmarks that enable portfolio managers and individual investors to compare their performance against an agreed-upon standard.
For example, an investor who focuses on large American companies might want to compare their portfolio’s returns to the performance of the S&P 500. If they receive higher returns than the S&P 500 as a whole, then they’re said to be “beating the market.” If they made lower returns than the S&P 500 in a given year, then they would have been better off investing in an index fund that perfectly tracked the S&P 500 instead.
Managers of index funds aim to mimic their chosen index as closely as possible in their portfolio mix – This means that the market index’s actual performance is an important benchmark for them. The closer that the fund follows the index’s performance (before fees), the better the fund manager is doing.
How is the value of a market index calculated?
Each market index can calculate its value differently, though typically the value is based on some form of a weighted average. Some indices are weighted based on market capitalization, while others use revenue or stock price to weight it. And, some indices do not use a weighted average at all – Instead, an equal weight is assigned to each company in the index.
For example, the Dow Jones Industrial Average is a price-weighted index. That means that it values companies with higher share prices more than companies with lower share prices, regardless of the market capitalization (aka dollar value of a company’s outstanding shares) of those businesses.
The S&P 500, by contrast, is a value-weighted index. It weighs companies with higher market capitalizations more than those with lower market caps, even if the companies with lower overall market caps have higher share prices.
How do you read market indices?
The values of market indices shift based on changes in the underlying stocks or other securities that they include.
On a given day, the prices of some securities included in an index will rise while others will fall. The index provides a snapshot of the overall trend of the shares included in the index. If the S&P 500 rises, that doesn’t mean that every company in the index gained value. It means that the value gained by the companies included was greater than the value lost by the other companies included.
Indices typically describe changes in the index both in terms of points and percentage. It is best to look at percentages when comparing index funds to market indices because this more accurately allows investors to determine whether they’re effectively mirroring the index’s performance.
Where can I find a list of stock market indices?
The Securities and Exchange Commission has a list of popular stock indices used in the United States. Foreign countries also commonly have stock indices that track a portion of or their markets as a whole.
Good places to find a list of popular market indices – and their performances – are financial news sites, magazines, and newspapers. Popular finance publications and local newspapers often publish the performance of major indices daily – This often includes the S&P 500, Dow Jones Industrial Average (DJIA), Financial Times Stock Exchange (FTSE) 100 and the Deutscher Aktienindex (DAX).
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