- An investment index is a measure of performance of a collection of investments.
- There are thousands of investment indexes, such as the DJIA, S&P 500, Nasdaq, and Russell 2000, that track different segments of the market.
- Once you understand what an index is measuring, it can be used as a benchmark to understand your portfolio's performance.
When you check a stock app on your phone, or turn on a financial news show, and see that stocks are up or down for the day, do you actually know what that means? Indexes are used to express how stocks and other assets, broadly speaking, are doing. But there are literally thousands of indexes, and each one is unique in some way.
Here's a deep dive into some of the most popular stock market indexes, and how you can apply them when investing or trading.
Indexes up close
An investment index is simply a measure of performance of a collection of investments (e.g., large-cap stocks, government bonds, commodities, etc.).
You can't invest directly in an index. However, indexes can be useful for a variety of reasons—first and foremost, in monitoring and analyzing the market, particularly as a benchmark (more on this later). For an index to be useful for gauging segments of the stock market, for example, you should understand what the index is attempting to measure and what the components are of that index.
Also, it is important to note that all indexes mentioned in this article are price-only indexes. The indexes' prices exclude the impact of dividends, which are a substantial component of the total return of the stock market. Only considering price and not the returns of dividends (including those reinvested) paints an incomplete picture of the total return of the stock market.
Let's take a closer look at some of the most commonly cited indexes.
Created by Charles Dow in the late 1800s, the Dow Jones Industrial Average (DJIA) was the first modern stock index to be created and widely used. For a long time, it was the most widely quoted index as a measure for how stocks performed.
It is a price-weighted index (i.e., the same number of shares of each component are included) that tracks 30 large-cap US companies. All companies within the Dow are considered blue-chip stocks, meaning they are widely recognized companies, with a history of consistent and stable earnings. The Dow's price reflects a broad measure of the changes in the individual stocks it tracks. As any of the 30 stocks it tracks change in value, so too does the DJIA.
Although the Dow is often referred to as an index of the stock market, due to its historic prevalence and importance, it has limitations as a benchmark for the broad US stock market. The Dow is rather narrow, consisting of only 30 companies, and all those companies are large-cap US corporations.
S&P 500 Index
The Standard & Poor's (S&P) Index tracks the largest 500 companies that are publicly traded in the US. It is a market-capitalization-weighted index, meaning that companies are represented in the index in accordance to their market cap. Given its breadth of large US equities, the S&P 500 has become one of, if not the most, widely quoted indexes of the US stock market.
The S&P 500 can be, and often is, used as a benchmark for US large-cap stocks. If you were looking for a benchmark of, say, small- or mid-cap stocks, the S&P 500 would not be an appropriate benchmark.
Additionally, because the S&P 500 is weighted by market cap, the index is subject to becoming inflated or depressed, relative to other similar non-market-cap-weighted indexes, if stocks that are heavily weighted in the index rise or fall dramatically. For example, at the end of Q2 of 2021, Apple® represented 5.5% of the entire S&P 500.*
The tech-heavy Nasdaq
The Nasdaq Composite Index tracks over 2,500 stocks. This index is market capitalization weighted. Unlike the DJIA, which represents only common stock, the Nasdaq also includes other securities, such as REITs, limited partnership interests, American depositary receipts, and tracking stocks. This tech-heavy index consists of close to 50% technology stocks.
Small caps and the Russell 2000
The Russel 2000 Index tracks the smallest 2,000 companies from the Russell 3000 Index (the latter of which tracks a wide breadth of 3,000 US securities). The Russell 2000 is weighted by market cap, but only tracks shares outstanding, meaning that only the value of shares that can be traded, and not a corporation's entire market cap is considered.
Outside the US market
Commonly referred to as "the footsie," the FTSE 100 tracks the largest 100 public companies by market capitalization on the London Stock Exchange. Like the S&P 500, the FTSE 100 is a market-capitalization-weighted index. The FTSE 100 could be a good benchmark of the performance of large-cap English (foreign) equities.
The Nikkei 225 is the most widely used index for Japanese stocks. Like the DJIA, the Nikkei only represents blue-chip large-cap equities, and is a price-weighted index.
How indexes and benchmarking may help you invest smarter
Once you know what an index is measuring, you can better understand how it can be used as a benchmark to measure your portfolio's performance. Without comparison to a benchmark, you could see gains and losses, but may not have the context to understand your investments' performance compared to the broader market, or to determine whether you investments' are over or underperforming.