Tracking the Markets

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A stock market index is a gauge of what’s up and what’s down.

Stock indexes and averages track day-to-day changes in the prices of groups of stocks and report longer-term trends in the stock markets. In fact, a market’s best-known indexes are sometimes used as snapshots of its economic health. They’re also benchmarks against which to measure the performance of investment portfolios.

Well-Known Index Names

Each index includes specific stocks and reports changes in that segment of the market. Some indexes are narrow, which means they track a limited number of stocks. Other indexes are broad. There are many indexes used to monitor the stock market, some common used of index name listed below is quite enough to broaden the view of beginners.

The Dow Jones Industrial Average (DJIA), despite its wide influence, is a narrow measure, tracking just 30 large-company US stocks drawn from several different sectors of the economy. The list changes from time to time as younger but powerful companies that are making a major impact on the economy replace those that have lost influence or fill vacancies created when listed companies merge. The DJIA is a price-weighted average.

Standard & Poor’s 500-stock index (S&P 500) tracks the performance of 500 widely held large-company stocks in the industrial, transportation, utility, and financial sectors. Together the 500 companies in this market-capitalization weighted index represent more than 75% of the US stock market’s value. The stocks included in the index, their relative weighting, and the number of stocks representing each sector vary from time to time, at S&P’s discretion. Recently, S&P revised the index to include only US companies.

The Russell 2000 tracks the stocks of 2,000 small US companies. It includes many of the initial public offerings (IPOs) of recent years and is considered the benchmark for small-company investments. The Russell 2000 is market-capitalization weighted.

The Wilshire 5000 is a market-capitalization weighted index of more than 7,000 stocks. It is the broadest US stock market index, tracking all the stocks traded on the NYSE, the AMEX, and the Nasdaq Stock Market.

Most countries with a stock market have at least one market index. For instance, the Financial Times 100-share index (known as the FT-100 and pronounced footsie), tracks the 100 largest companies listed on the London Stock Exchange. The CAC 40 tracks the Paris Stock Exchange, the Heng Seng follows Hong Kong Stock Exchange, and the KSE-100 reports actively on the Pakistan’s Karachi Stock Exchange. Each index is independent of the others, but a gain or drop in one of the major indexes often influences what happens in other markets during the next trading day.

The broadest indexes, known as global or world indexes, give a picture of stock performance around the world. Two of the most prominent are the Morgan Stanley World Index and the Dow Jones World Index. There are also indexes, like the Morgan Stanley European Australasia Far East Index (EAFE MSCI), that cover specific regions of the world, in this case Europe, Southeast Asia, and Australia.

Using Indexes and Averages

A stock market index or average is often considered a benchmark, or yardstick, against which to measure the performance of an individual stock or portfolio of stocks. For example, US investors and financial advisersoften use the S&P 500 as a benchmark to evaluate the performance of individual large-company stock investments in relation to movements of that market as a whole.

If you own stocks in companies of a particular industry, like communications or banking, you might compare their performance against an industry index that tracks companies involved in the same business, or sector.

You might also invest in exchange traded funds (ETF) or index mutual funds to fill holes in your diversified portfolio. For example, if you own only large-company stocks, you might choose a fund tracking small companies. Both types of fund invest to replicate the performance of a particular index, though the two aren’t exactly alike.

ETFs are listed on a stock market — most of them on the American Stock Exchange (AMEX) — and trade like stocks. Index funds, on the other hand, are priced once a day as other open-end mutual funds are. You trade ETFs through a broker, and may buy index funds through a broker, another financial adviser, or directly from the fund sponsor.

Weighty Matters

Most stock indexes are weighted to reflect the impact that price changes in certain stocks have on various markets and economies.

A market-capitalization weighted index, such as the S&P 500, counts price changes in companies with the highest market capitalization, calculated by multiplying the current stock price by the number of existing shares, more heavily than price changes in smaller companies in the index.

A price-weighted index, such as the DJIA, counts changes in the prices of the highest priced stocks among those that it tracks more heavily than it counts price changes in stocks selling at lower prices even if the companies are of similar size.

The significance of weighting is that a relatively few stocks can drive an index up even when most stocks in that index have stayed flat or even lost ground. This can work the opposite way in a downturn, when a few large-cap stocks might lead an index sharply down, while the average stock price drops just a little or not at all.

On the other hand, rising or falling prices for the largest companies or highest-priced stocks tend to have a much greater impact on investor attitudes and on the economy as a whole than price changes for smaller companies do.

Index or Average?

Have you ever wondered why some stock market benchmarks are called indexes and others are called averages?

Basically, to find an average you add the prices (or weighted prices) of the stocks you’re tracking and divide by the number of stocks. To construct an index, you establish a baseline value and a starting point, and express changes in the combined value of the stocks in the index as a percentage change from the base year, the previous month, or the previous day. For example, on a particular day, the S&P 500 may be up (or down) 1% from the previous day, and 10% for the year-to-date (YTD).

The best known financial average, the DJIA, is actually a hybrid. It’s computed by adding the weighted closing prices of its 30 stocks and then dividing not by 30, but by a number that has been adjusted over the years to account for changes including additions, deletions, and mergers, as well as stock splits. Upward or downward movements of the DJIA are reported in the same way that movement is reported in an index, as a percentage change.