A market index provides an idea about how a given stock market is performing. It represents a large enough sample of the overall number of stocks in that market and can be considered a good enough proxy of the overall development of the market.
It would be too difficult to measure the development of every security traded in a stock exchange. Some securities are small, and their shares are not even traded daily. That’s why practitioners use market indices to provide an idea of the overall market performance.
The three most famous indices in the US are the S&P 500, Dow Jones Industrial Average, and NASDAQ.
The S&P 500 comprises 500 of the largest listed companies. The diverse constituency of the S&P 500 makes it a true approximation of the US stock market. It is a market-cap-weighted index, so companies are weighted according to their market value. If the market cap of P&G is 3 times the market cap of Nike, a 1% change in P&G’s share price will have three times the impact of a 1% change in Nike’s price.
The Dow Jones industrial average index uses an average of 30 large public stocks traded in the US market. The Dow Jones Industrial Average is one of the oldest indices calculated historically. However, it cannot be used as a representation of the US stock market, because it includes only 30 stocks.
The other important US index we’ll cover is the NASDAQ composite index. It is an index grouping some securities that are listed on the NASDAQ stock exchange. Most companies listed there are information technology companies, and NASDAQ shows us about the rate of return of tech stocks.
These are the three important US indices.
Let’s consider some foreign indices well-known for professional investors.
Examples of such indexes are the FTSE 100 in the UK, the DAX in Germany, the Nikkei 225 in Japan, and the SSE Composite Index in China.
There are some global stock indices as well – Morgan Stanley’s Morgan Stanley Capital International (MSCI). This index includes stocks from all developed markets in the world.
Why is it important to know what stock indices are and how are they performing at a given time?
If you want to understand whether one of the stocks you own is performing well, one of the best comparators you can use is a stock index. Compare the stock against the overall market performance.
In addition, a stock index gives you a sense of the type of return you can expect if you invest in a well-diversified portfolio in a given market.
Let’s see how we can calculate the historical returns of some stock indices we mentioned in this article. It will be interesting to observe how much the rates of return of the S&P500, the NASDAQ, and some foreign indexes were. We’ll do that in our next article!