Indexes: Measuring the Market

If you watch the news or read the newspaper you’re probably familiar with market experts saying things like “the Dow Jones is down 20 points” or “the market is up 5% over the last three months”. But what does that actually mean? What is the Dow? How much is a “point”? Understanding how financial institutions measure the financial market is an important part of understanding the market.

Indexes: What are They?

When the experts refer to the market they are talking about all the stocks available on the major stock exchanges. However, since there are thousands of stocks available, they use tools called indexes to measure the market. An index is basically an average of all the companies that are included in the index. The companies are weighted for size. This means that a change in the stock price of a big company like Walmart has a bigger effect on the index than a smaller company, such as Jack in the Box.

There are indexes for everything imaginable. Certain indices follow market sectors, commodities, and exchange rates. Even though there are hundreds of indexes, there are a few that are used much more than the rest. We’ll take a look at two of the most commonly used indexes and which companies make up portions of them.

Famous Indexes

Probably the most prolific index is the Dow Jones Industrial Average. Established in 1896, it was created to give a measure of the American economy. The Dow Jones consists of 30 large companies traded on the New York Stock Exchange (NYSE) and the NASDAQ. It is regularly updated as certain companies and industries fall in an out of favour. The Dow is more heavily weighted towards stocks with a higher price. The last change to the Dow was the addition of Apple in 2015, when it replaced AT&T. When “the market” is referred to on television, they are almost always making reference to the Dow.

Another famous index is the Standard & Poor’s 500. The S&P 500 is made up of 500 companies selected by a team of economists. The S&P 500 is considered the most accurate measure of large cap stocks. This is because it weights companies by size, unlike the Dow which weights by price. Also, the 500 stocks included in the S&P 500 contains a much larger share of the market than the 30 included in the Dow.

Index ETFs

In several of our previous articles we’ve been singing the praises of index ETFs (seriously though they’re great. See here). An index ETF is an ETF which is designed to do exactly what a certain index does. Since you can’t actually buy an index the ETF will never perfectly mirror the index it is supposed to follow. However, most of the time ETFs will do a good enough job of following its index that it makes no difference. The reason for the accuracy is because the ETF managers can look up what stocks make up an index, by the same stocks in very similar proportions and voila, the ETF will follow the index extremely closely.

Indexes are the most fundamental measurement of market health. Broad “market” generalizations come from indexes, which are averages of a bunch of different publicly traded securities. So next time you see someone on the television talking about the bull market you’ll know what it means and how they know what the market is doing on average, which can help you make your own financial decisions.

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