As you become more involved in the stock market, you’ll begin to hear a lot of talk about stock indices. What is a stock index exactly, and how can they help us to invest?
Getting into the world of investing can often seem a lot more difficult than it should be.
At Rubicoin, we believe that anyone can shape their financial future through investing. But new investors can sometimes become confused or misled by unnecessary and irrelevant information.
This week, we’re going to look at one of the major aspects of investing that ends up confounding new investors—stock indices.
What Is A Stock Index?
Simply put, a stock index is the calculated average of a selection of different company share prices. It is usually divided up according to a specific market, sector, or country.
Think of it as though a selection of stocks from different companies have been spread out on a table for you to see. By looking at the average performance of all of these stocks together, you’re able to get get a good idea of the health of a particular industry.
You’ve probably heard of big indices before like the Dow Jones, the Nasdaq and the S&P 500. Maybe you’ve even heard of some of the smaller ones like the Russell 2000, or international indices like the FTSE.
All of these indices feature different companies of different sizes and sectors. A lot of them are even calculated in different ways. But their main purpose is to give investors a broad idea of how companies are performing.
What Are The Main Stock Indices?
So now that we know what indices are, which ones should we be on the lookout for?
- The Dow – The Dow Jones Industrial Average, to give it its proper title, is the oldest and most well-known stock index in the world. It includes 30 stocks from the largest companies in the US. The Dow represents about a quarter of the value of the entire US stock market, though it is not as closely followed as the S&P 500.
- The S&P 500 – The Standard & Poor’s 500 is, funnily enough, made up of 500 stocks from the US stock market. As such, it represents almost three-quarters of the total value of the US stock market and can give a really good indication of the state of the market. When financial commentators talk about ‘the market’, they are usually referring to the S&P. It includes stocks from a wide range of sectors, including energy, IT, and healthcare companies.
- The Nasdaq – The Nasdaq Composite Index is most commonly known as the technology index, although it does include stocks from other areas like the financial and industrial sectors. The Nasdaq is market-weighted like the S&P 500, and also includes many speculative companies with smaller market caps. This means that the Nasdaq can often give investors a good impression of how the market is reacting towards less well-established companies.
Why Do Stock Indices Change?
Almost every news report from across the world finishes up with a short segment on global stock indices which tells us about their performance—whether they’ve gone up or down.
But what exactly do we mean when we say The Dow is up, and what causes it to move?
Market sentiment changes daily, and although many commentors try to simplify the movements of the market, it really is a complex beast. Major economic and world events—including things like the recent Brexit vote or poor unemployment figures—affect the share prices of thousands of companies, even those indirectly involved.
When the share prices of major companies rise or fall, the value of any index they are included in will shift—particularly if they are a large company.
Thankfully, major drops in market prices are quite often a relatively temporary trend, and as soon as the next big ‘Man Bites Dog‘ story breaks, prices (and in turn, indices) begin to stabilize.
How Should We Use Stock Indices?
When investing, it’s important not to become too fixated on the small fluctuations in the short-term market that might distract you from the long-term growth.
But indices can be a useful tool in terms of giving investors a broad overview of market trends. In fact, one of the best uses of stock indices is to remind investors that despite daily fluctuations, the market generally grows in the long-run.
Indices also act as a good benchmark for how your portfolio is performing. Remember, if you’re not confident enough to invest in individual stocks, you can always invest in an index fund or ETF (like the Vanguard S&P 500 ETF or the Proshares Dividend Aristocrats ETF). This is like owning a little bit of each of the 500 companies that make up the S&P 500. This is seen as a very low-risk way to get investing in the stock market as the S&P 500 has historically increased over the long-term.
But if you’re interested in picking your own stocks, you can still use the S&P 500 as a benchmark. You’re taking added risk when you invest in individual companies, so you want to be able to beat the low-risk alternative.