What Is A Stock Index?
“The stock market turned in a great performance”, or “The markets crashed today”. What exactly are “the markets”? When most people speak of the markets they are referring to a stock index.
Here in America, we have three major indexes (or indices), the Dow Jones Industrial Average, S&P 500, and NASDAQ. Turn on any financial show or open any financial newspaper and you’ll see references to these three indexes every single day.
It would be very difficult to track every security trading in America. To get around this, we track a small selection of stocks to represent the market as a whole. An Index monitors a small selection of stocks and based on what happens to them determines the market in whole.
The First Stock Index Was The DOW
Charles Dow started the first stock index back in 1896. At that time the DOW contained only 12 of the largest companies in the US. Today the Dow Jones Industrial Average contains 30 of the largest companies in the US.
Before computers, calculating the index had to be simple. When the DOW first started, they would take the closing price of all 12 stocks, add them up, and divide by 12 to get the average. Not fancy, but it served its purpose in determining whether the markets went up or down and by how much.
Today, the DJIA uses a different methodology called price-based weighting. The other two main indexes, NASDAQ and the S&P 500 weigh companies based on market capitalization. Computers do the calculations automatically nowadays and we can instantly watch these indexes move up and down.
What Is A Stock Index?
It is important to note that a stock index is nothing more than a list of stocks and anybody can create one. If you wanted to copy the DOW, all you need do is hold equal amounts of all 30 stocks and your returns should be the same as the DOW
Nowadays, investors don’t need to purchase all 30 stocks on the DOW or all 500 stocks on the S&P to copy the returns of that index. There are investment vehicles like Index funds or ETF’s one can invest in to keep things much simpler.
The DOW has stood the test of time as a reliable indicator of “blue chip” companies. It’s not risky and not too volatile either. However, with 10,000 stocks to choose from in all market caps, it’s not a good indicator of the overall general market.
To get a better idea of how the market is behaving, I prefer the S&P 500. It covers a much broader spectrum of the stock market. It is increasingly seen as the benchmark of the U.S. stock market. In fact, the performance of most equity managers is pegged against the S&P 500.
An index is also used as a comparison tool. Mutual fund managers try to beat the S&P’s returns (unfortunately most mutual funds under perform the S&P 500) and many use it to gauge whether they are a good investor or not.
For example, if your friend tells you he made 50% last year, it may sound good. However, if the markets (or indexes) went up 100%, he did horrible. A stock index can measure whether you (or anyone for that matter) are a good investor or not.
Make Money With A Stock Index
One way to make money with an index is to simply buy an ETF that tracks that index. I prefer leveraged ETF’s that return 3x what that index does. For example, historically the markets rise 11% per year over the long-term. Therefore, anyone who buys a 3x ETF that tracks the S&P 500 (UPRO is a good choice) should average a return of 33% per year (11% for the markets x 3). Most mutual funds rarely return 33%. If you are not averaging 33% in your investing, then you may want to consider just buying and holding UPRO.
In conclusion, a stock index is a collection of stocks whose prices are used to calculate the value for that index in order to be able to judge the markets as well as judge an investor’s skill at stock picking .