Stock Indexes in the News

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Stock Indexes in the News

Stock indexes are in the news a lot. But what exactly are they?

A stock index is simply a grouping or a composite of a number of different stocks, often with similar characteristics. Stock indexes are typically used to discuss the overall performance of the stock market, in terms of changes in the market price of the stocks as well as how much trading activity there is in any particular period. Three of the most widely followed indexes are the Dow Jones Industrial Average, the S&P 500, and the Nasdaq Composite Index.

The Dow Jones Industrial Average

Known as just the "Dow" for short, this index is not really an average, nor does it exclusively track heavy industry anymore. The index is composed of 30 large stocks from a wide spectrum of industries. General Electric (GE) has been the longest-tenured constituent of the Dow, which has changed substantially over time.

How is this figure calculated?

The index is calculated by taking the 30 stocks in the average, adding up their prices, and dividing by a divisor. This divisor was originally equal to the number of stocks in the average (to give the average price of a stock), but this divisor has shrunk steadily over the years. This shrinkage is needed to offset arbitrary events such as stock splits and changes in the roster of companies.

Because the Dow includes only 30 companies, one company can have much more influence on it than on more broad-based indexes. Also, since the prices of the 30 stocks are added and divided by the common denominator, stocks with larger prices have more weight in the index than stocks with lower prices. Thus, the Dow is a price-weighted index. It’s also useful to remember that the 30 stocks that make up the Dow are picked by the editors of The Wall Street Journal, rather than by any quantitative criteria. The editors try to pick stocks that represent the market, but there’s an inevitable element of subjectivity (and luck) in such a method.

Despite its narrower focus, the Dow tracks quite well with broader indexes such as the S&P 500 over the long run.

The S&P 500

The Dow Jones Industrial Average usually gets most of the attention, but the S&P 500 Index is much more important to the investment world. Index funds that track the S&P 500 hold hundreds of billions of dollars, and thousands of fund managers and other financial professionals track their performance against this ubiquitous index. But what exactly is the S&P 500, anyway?

The Standard & Poor’s 500 as we know it today came into being on March 4, 1957. The makers of that first index retroactively figured its value going back to 1926, and they decided to use an arbitrary base value of 10 for the average value of the index during the years 1941 through 1943. This meant that in 1957 the index stood at about 45, which was also the average price of a share of stock. The companies in the original S&P 500 accounted for about 90% of the value of the U.S. stock market, but this percentage has shrunk since then as the number of stocks being traded has expanded.

Although it’s usually referred to as a large-cap index, the S&P 500 does not just consist of the 500 largest companies in the U.S. The companies in the index are chosen by a committee at investment company Standard & Poor’s. The committee meets monthly to discuss possible changes to the list and chooses companies on the basis of "market size, liquidity, and group representation." New members are added to the 500 only when others drop out because of mergers or (less commonly) a faltering business.

Some types of stocks are explicitly excluded from the index, including real estate stocks and companies that primarily hold stock in other companies. For example, Berkshire Hathaway (BRK.B), the holding company of Warren Buffett, arguably the world’s greatest investor, wasn’t included until 2010, despite having one of the largest market values of all U.S. companies. Also, the index is composed exclusively of U.S. companies today.

Size matters with the S&P 500. Because the companies chosen for the index tend to be leaders in their industries, most are large firms. But the largest of the large-capitalization stocks have a much greater effect on the S&P 500 than the smaller companies do. That’s because the index is market-cap-weighted, so that a company’s influence on the index is proportional to its size. (Remember, a company’s market cap is determined by multiplying the number of shares outstanding by the price for each share.)

The Nasdaq Composite

The Nasdaq Composite was formed in 1971 and includes the stocks of more than 3,000 companies today. It includes stocks that are listed on the technology-company-heavy Nasdaq stock exchange, one of the market’s largest exchanges. (Other major stock exchanges include the New York Stock Exchange, or the NYSE.) Like the S&P 500, the Nasdaq is a market-cap-weighted index. For a stock to be included in the Nasdaq Composite, it must trade on the Nasdaq stock exchange and meet other specific criteria. If a company fails to meet all of the criteria at any time, it is then removed from the composite.