Stock indices exemplify the significance of equities generally, which have existed in America since the late 1700s. This market follows the ups and downs of a chosen group of the most popular shares in the markets rather than sifting through the many standalone stocks behind them.
Interestingly, about 5000 stock indices exist in the entire American equities market. However, this article will introduce you to only the most popular and why investors are interested in them.
What is a stock index?
One of the dictionary definitions of an index is ‘a measure of something.’ Therefore, a stock index is a basketed financial instrument consisting of numerous stocks to measure a particular market sector.
The area might be as broad as an index like the S&P 500 (Standard & Poor’s 500) or as niche as the DJIA (Dow Jones Industrial Average), covering the top 30 large-cap US stocks.
Every index in the US equities market is calculated based on a particular method. Two of the most common methodologies are market cap and price. The S&P 500 is an overall market cap-based index.
With this method, the index’s price prioritizes the market capitalization of all 500 constituents (the share value of each company divided by the number of outstanding shares).
With price weighting (popularly implemented by the DJIA), an index takes the share price of each constituent stock divided by the sum of all stock prices.
Other calculation methods for indices include free-float adjusted market cap, fundamental factor, equal, minimum variance, volatility, or a combination of these.
List of the most popular US-based stock indices
When the average Joe or the media reports about US-based stock market indices, they often refer to the ‘big three,’ namely the S&P 500, the Dow Jones Industrial Average, and the NASDAQ Composite Index.
Other relatively popular indices worth mentioning are the Wilshire 5000 (similar to the S&P in coverage) and the Russell 2000 (for small-cap equities).
S&P 500 (^GSPC, $SPX, INX, US500, or USA500): The S&P 500, or simply the S&P, is a market-cap-weighted index tracking the performance of the top 500 large-cap US stocks.
It was created in 1957 and remained the largest both in America and globally. The S&P represents about 80% of the entire value of the US stock market and covers 11 sectors, with information technology, healthcare, and communication accounting for approximately half.
S&P Global, an American index provider, maintains the S&P 500. This index is widely regarded as the barometer for the health of the equities market in America holistically.
Dow Jones Industrial Average (^DJI, $INDU, DJI, or DJIA): Often simply referred to as the Dow or Dow Jones, the DJIA is a price-weighted index maintained by S&P Dow Jones Indices.
It is the oldest stock index globally, having been created in 1885. About 25% of the entire value of the US stock market is tied to the Dow.
The index tracks the performance of the top 30 blue-chip American stocks from the NASDAQ and New York Stock Exchange, and hence, is a prominently used yardstick for this particular sector.
NASDAQ Composite Index (^IXIC): The NASDAQ Composite is a market-cap-weighted index consisting of nearly all the +/- 3500 NASDAQ-listed stocks.
The index was established in 1971 and has historically been heavily tech-focused. Most of the constituents in IXIC are massive information technology corporations, meaning the index is used to represent this specific category.
Wilshire 5000 (^W5000): The Wilshire 5000 is often referred to as the ‘total stock market index.’ Despite being mentioned far less frequently than the broad-based S&P 500, it covers roughly 3500 stocks (5000 at some point in time; hence the name).
Thus, like the S&P, it is market cap-weighted and technically represents the US stock market at large as it contains even more of the large-cap publicly traded American companies.
The index was established in 1974 by the investment management firm Wilshire Associates Inc., which still manages the index to this day.
Russell 2000 (^RUT): While all the previous indices cover large-cap companies, the Russell 2000 exclusively tracks the performance of around 2035 small-cap companies forming part of the Russell 3000 index.
This market is used as a benchmark for small-cap mutual funds. The free-float capitalization-weighted index was launched in 1984 and is now managed by FTSE Russell.
Small-cap stocks have market caps below $2 billion, while over $10 billion for large-cap shares.
Why stock indices are so popular
The whole purpose of a share is to raise capital and reward shareholders when their businesses perform well with dividends or other financial rewards.
If corporations grow their bottom line, it increases prosperity, growth, and, most importantly, jobs within an economy. Of course, a much better quality of life and economic trade comes with more jobs.
Therefore, it’s widely known that US stock indices often provide a reliable bird’s eye view of how the American economy is performing overall. Another reason why stock indices are essential is for diversification.
Experts consider investing in individual stocks as being riskier. However, with something like an index fund, an investor is more diversified and doesn’t need to simultaneously analyze the many macroeconomic factors of different stocks.
This method is regarded as a safer, quicker, and cheaper alternative to investing in equities generally.
As you can imagine, there are many ways of getting involved in US stock indices. The old-school, tried-and-tested method, often promoted by investing gurus such as Warren Buffett, is buying index funds and ETFs (exchange-traded funds).
If you don’t like this passive, slower approach, one can always try their hand at the more aggressive leveraged online CFD (contract for difference) trading.
Overall, stock indices are an essential component of any economy as they measure the general health of many different sectors at a glance. Moreover, indices might prove a less daunting way of getting involved in stock trading and investing for less knowledgeable individuals.