A market index, as the name indicates, tells about the market trend. We hear an often-repeated expression in the media: The Dow is up so the market is upbeat. Or, the Dow is down, so the market is depressing.
Dow actually stands for Dow Jones Industrial Average, but it is mostly referred to just Dow. Dow represents the pulse of the stock market.
Index numbers that represent the state of stock market can be calculated in different ways. An index number, it must be noted, denotes the change from the original or a base value. The index number, by itself, is not important. What is important is the percentage of change over a period of time. Instead of saying how the market is performing, we say how the index is performing. We, therefore, ask: Is the Dow up or down?
The index is calculated “on the fly” during the trading period. It gives the investors a sense of direction of the market. The index, therefore, reflects “the market it represents” and not the” market” as a whole. Most market indexes are known only to represent only a part of the market and not the actual market.
Besides Dow, the other important stock market indexes are the Standard and Poor 500 popularly known as S&P 500 and the NASDAQ Stock Market Composite. Both Dow and Nasdaq refer to an index or an average based upon the price movements of certain stocks. Each represents only a mathematical average that investors use to form an idea of the stock market.
Here is a brief description of each of these three market indexes.
The Dow Jones Industrial Average is the oldest and the most popular and widely quoted index of all the three indexes. It is also considered a barometer of stock markets.
Dow was originally used as a simple average of stocks in the index. With the passage of time, the increased complexity of stock market and other transactions have made it more sophisticated. The Dow presently covers only 30 major stock market players owned by the most influential companies of the United States. All these companies make annual revenue of over $7 billion.
Dow is the only index that is weighted by price. It means that if the price of a stock changes by one dollar, the change has the same effect on the index irrespective of percentage change in the price of the stock.
The total wealth of the thirty Dow stocks is equal to one fourth of the wealth of the total US stock market. Dow obviously does not represent the small and mid sized stocks at all. But any change in the Dow index affects the investor confidence in stocks as many people consider Dow to indicate how the overall stock market is performing.
It must be noted that Dow or the DJIA is not the same as Dow Jones and Company that publishes in the Wall Street Journal although the people who edit the Wall Street Journal also maintain the DJIA and other Dow Jones indices.
S&P 500 is the most frequently consulted index by financial experts who consider it to be the true indicator of the market position. As against 30 stocks covered by Dow, S&P 500 covers 500 of the most popular and big stocks. S&P 500 includes the stocks that own about 70% of the total wealth of the US stock market.
S&P 500 is a market capital weighted index. Therefore it gives more importance to large companies. Any change, for example, in Microsoft stock will exercise more impact than almost any other stock in the index. Unlike Dow, S&P500 provides more accurate idea of the broader market.
The Nasdaq Stock Market Composite
The Nasdaq Stock Market Composite is the most representative of the three popular indexes as it covers more than 5,000 stocks. Despite being representative of such a large number of stocks, Nasdaq is heavily weighed in favor of technology stocks.
It is also a market cap weighed index like the S&P 500. Therefore technology based companies like Microsoft influence its index. Since this index is comprised of small and speculative companies, their influence makes this index more volatile than both the Dow and the S&P500. Although Nasdaq does not represent the entire market, it does provide a fairly good idea of the prices of the technology stocks.
Despite their limitations, all these three indexes provide very useful information about the price trends and changes in the investment patterns and give a fairly accurate picture of the stock market. They also help the investors to compare the stock markets.