A stock market index measures the performance of a particular “basket” of stocks, representing a specific industry or region. Investors use these market indexes in many ways—to analyze current market conditions, identify industry trends, and invest in index funds.
To help you better understand how market indexes work and how investors use them to their advantage, here’s a deep dive into the inner workings of stock market indexes.
What is a Market Index?
A stock market index tracks a specific group of stocks in a market segment, like a specific industry or region. Indexes can tell investors and financial institutions a lot about specific investments, the sector as a whole, even the overall economy. Here are a few insights investors look to indexes for:
• To understand how the economy is performing
• To help with trend forecasting
• To create benchmarks to evaluate a particular investments’ profitability
Take, for example, the S&P 500, which tracks the 500 largest publicly-traded U.S. companies in the stocks market. Each company is carefully selected to embody every primary industry, thus creating a replication of the market as a whole. Conceptually, an investor might look at the past performance of the S&P 500 to assess whether the stock market is emerging or receding.
How Stock Market Indexes Work
Indexes are made up of hundreds and sometimes thousands of stocks. However, the index doesn’t evenly assess each stock. Depending on what stocks have higher weight in an index, their performance may have more or less influence on how the index performs overall.
There are a few ways indexes are typically weighted:
• Price weighted: In price-weighted indexes, the stocks with the higher price will have a greater influence on overall performance than those with lower prices.
• Capitalization weighted: These indexes look at the total value (or market capitalization) of each stock’s outstanding share to determine its weighted value, giving smaller market caps a lower percentage weighting, and higher market caps a larger one.
• Value weighted: A light math formula is employed in this type of index, where the price of the stock is multiplied by the number of outstanding shares.
• Equal weighted: In this index type, all stocks are given equal weight, regardless of market cap, value, or price.
Types of Stock Market Indexes
While there are many indexes investors and financial professionals can follow, here are a few examples of stock market indexes.
• S&P 500. The S&P 500 measures the largest publicly-traded U.S. stocks. Financial professionals use the performance of the S&P 500 as a basis to compare other investment options.
• NASDAQ Composite Index. The NASDAQ Composite Index measures over 3,000 global and U.S. stocks registered on the NASDAQ stock market. Because it covers so many stocks, it is one of the most followed and quoted indexes. Some of the types of stocks include common stock and real estate trusts (REITs).
• Dow Jones Industrial Average. The Dow Jones Industrial Average, commonly known as the DJIA, measures 30 US-based blue-chip stocks that are often referred to as the foundation of the U.S. economy. These stocks usually include companies in market segments of the economy, with the exception of transportation and utilities (the Dow Jones has separate indexes for those two sectors).
• Russell 2000 Index. In contrast to the S&P 500, which follows large-cap stocks, the Russell 2000 follows 2000 of the smallest companies in the U.S. market, making it a good benchmark for small, publicly-traded companies.
How to Invest in a Stock Market Index
Although it’s possible to purchase all stocks within a particular index, this method might be too time-consuming, complicated, and potentially expensive. Another option is to invest in ETFs or index funds or that attempt to replicate indexes’ performance, known as an index fund. This investment strategy is often referred to as index investing.
With index investing, investors can effortlessly access index funds. By investing in index funds, they can also follow some common investing pillars, such as diversification. For example, investing in an index fund helps investors exercise a diversification strategy instead of a strategy centered around stock-picking and market timing.
Advantages of Investing in a Stock Market Index
As an investment strategy, index investing has certain benefits that may attract investors. These are the big ones.
Index Advantage: Simple Investment Management
By investing in a stock market index, investors may earn better returns with minimal effort, making index investing an easier way to manage their investments.
Investing in a stock market index is typically considered a passive investing strategy, where investors buy and hold securities to hopefully capitalize on long-term gains. Conversely, active investors buy and sell securities with the intent to beat the market or some form of index returns.
Because active investors are more hands-on, it’s easy to assume that they may reap higher returns than what the average index investor would see. But that’s not necessarily so. In fact, according to the SPIVA Report , over the past five years, 77.97% of actively managed large-cap funds underperformed the S& P 500.
In addition to most actively managed funds underperforming their passive investing counterparts, active investing requires a lot of time, analysis and is often very challenging.
Index Advantage: Diversification
Diversification is considered by some to be one of the vital building blocks of a thorough investment strategy. With diversification, investors spread their investment across various assets instead of putting all of their money into a single security.
Since investments may perform differently in dissimilar economic environments, diversification may help investors minimize their risk exposure. In other words, if one investment drops in value, investors still have other investments to potentially make up for the loss.
A stock market index fund packages many different stocks in an individual investment, providing nearly instant diversification, vs. investing in just one stock.
Index Advantage: Minimal Barriers to Entry
For investors on a strict budget, it might be challenging to invest in more than just a few companies. However, by investing in a stock market index, they have exposure to a large assortment of stocks using the same amount of cash.
What’s more, investors don’t need the assistance of a money manager or financial advisor to invest in an index. That said, it’s still essential to review any related fees and costs. While indexes tend to have lower taxes and fees, it’s generally a good idea to review all costs involved in any investment before moving forward.
Disadvantages of Investing in Stock Market Indexes
Few things in life are perfect, and that includes investments. Here are some common disadvantages of investing in stock market indexes.
Index Disadvantage: Not a Short-Term Investment Strategy
Because indexes follow the market, their value increases incrementally, making them a better long-term investment strategy than short-term. Investors may also see fluctuations in returns, since they’ll go through various business cycles—Which means that at times, investors may see very small, if any, increases to their portfolios.
Index Disadvantage: They Don’t Fully Follow a Certain Index
Stock market indexes may closely chart the index they track, but they may not perform exactly how the entire index performs. This is because indexes typically don’t include all of the stocks within a particular index; they only include a snapshot of the index as a whole. Thus, the index fund can’t wholly mimic the performance of the entire index.
However, while the index doesn’t directly mimic a stock market’s performance, it tends to have similar price fluctuations. So, if the market increases, typically the index will as well.
The stock market index is a useful way for investors and analysts to get a sense of how a certain segment of the market is performing—whether that’s the top 500 publicly-traded large-cap US companies or the bottom 2000 small-cap ones. It’s also a way for investors to diversify their portfolios in one move, by investing in an index fund or ETF.
For investors who are interested, the government recommends reviewing all of the information available on a particular index, including the fund’s prospectus and most recent shareholder report. You may also want to identify the fees, your investment goals, and the investment risk of investing in a particular index.
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