In this video we will answer some key questions about market indices: 

First, what are stock market indices, and why is it important for you as an investor to understand them

Then we will find out what stock market indices do, and how they impact the market 

Finally, we will take you through the most important indices of US stock market:

  • S&P 500
  • Nasdaq 100
  • Down Jones

Let’s dive in!

Why stock market indices are important for you as an investor?

First, let’s address why indices are important to understand for an investor.

A financial market allows investors to make a profit from market volatility that occurs frequently. It is also a place where investors can track and compare the performance of stocks, shares, and other securities. 

With the many stocks listed on the stock market, it’s difficult to get a sense of the market with the performance of one single stock. That is why indices are important. Investors can get an overall picture of the performance of stocks in a particular sector or economy by using market indices. These indices help investors stay informed of how the stocks in the index perform, and therefore help them determine whether they should make an investment.

It is important to note that while market indices may move on a daily basis, and it is important to track them, investors should not make decisions solely based on daily movement of stock indices. Rather they should do proper due diligence before buying or selling a stock. 

What are market indices? What do stock market indices do?

So, what exactly are market indices, and what do they do? And which are the most important market indices for the US markets?

Like we discussed, a market index tracks the performance of a diverse selection of securities that make up a significant part of the financial market. It serves as an indicator of the overall financial market condition by making it easier to read historical and real-time trends across different market segments.The rates of stocks, bonds, or mutual funds determine the value of an index. 

The S&P 500, the Nasdaq 100, and the Dow Jones Industrial Average are the three most prominent stock market indices in the U.S. Let’s understand each of these in more detail.

S&P 500 Index 

Let’s start with the S&P 500. This is a stock market index that tracks the stocks of 500 large-cap U.S. companies. It represents the US stock market’s performance by reporting the risks and returns of the biggest companies – yes, the FAANG companies, namely Facebook, which is now Meta, Apple, Amazon, Netflix, and Google are all a part of the S&P 500. These companies, in fact, drive the S&P 500 index. Investors use it as the benchmark of the overall market, basically a reference to which all other investments are compared. 

Nasdaq 100 Index

Next, let’s look at the Nasdaq 100. The Nasdaq includes the stocks of the 100 largest nonfinancial companies listed on the stock exchange. 

Nasdaq imposes some very specific requirements for companies to be listed under Nasdaq 100. A company needs to be achieving an average daily volume of 200,000 shares and it should be listed on the market for at least three months to be listed on this index. Interestingly, the Nasdaq 100 was limited to 100 stocks originally, but, today, it consists of 107 equity securities issued by 100 companies. 

If we compare the two indexes, Nasdaq is an Information Technology heavy index, while the S&P 500 Index is a more broad-based index. There are a hundred stocks listed on Nasdaq while on S&P 500 Index, there are 500 stocks, thus giving a much diversified flavour to those who want to diversify their international portfolio. Further, there are large and mid-cap stocks listed on Nasdaq while S&P 500 Index has only large-cap stocks.

Dow Jones Industrial Average

DJIA stands for Dow Jones Industrial Average, which is commonly referred to as the Dow Jones index. The Dow Jones index only includes 30 companies. It is one of the oldest indexes in the US markets, and is over 120 years old! The primary purpose of the DJIA is to track and reflect the average performance of the 30 major U.S. industries. Companies like American Express, Nike, and Coca Cola are a part of the Dow.

How are these indices different from one another?

While the basic mission of these three market measures is similar, the way they go about the task is very different. And for that reason, all three measures can give you a completely different take on how stocks are doing.

The first difference is the calculation methodology. The Dow Jones industrial average assigns a greater weight to stocks with the highest per-share price. That means that IBM, trading for nearly $200 a share, has a much greater weighting than Bank of America, which trades for less than $10 a share.

The S&P 500 index is calculated based on two key factors: the market cap and the market float of shares. The index is primarily weighted by the first factor which is the market cap. This means that the large companies like Apple and Google have more weightage. As the companies grow in size, the index is driven more and more by their market cap than the rest of the stocks. Interestingly, FAANG companies make up about 19% of the S&P 500 which is a staggering figure considering the S&P 500 is generally viewed as a proxy for the United States economy as a whole! 

The second factor is the market float. This is calculated based on the number of free float shares and not the total shares. Free float shares are those that are publicly traded versus total shares which also include shares held privately by insiders. This is why large companies that have big slices of their company held by a founding family, with shares not being traded in the public’s hands, don’t hold as much value in the S&P 500 index.

The Nasdaq 100 index, lastly, is weighted based on market cap as well. That means the companies with the greatest total market cap hold the most weightage in the Nasdaq.

The second difference is the type of companies that are included. The Dow tracks the value of 30 large companies which tend to be blue-chip firms that are household names. The S&P 500 tends to be broader, hoping to have a bigger representation of companies from various sectors and industry groups. And the Nasdaq 100 includes only non-financial big technology stocks that are traded on the Nasdaq market.

Just these two characteristics can create three very different indices. The Dow tends to be the blue-chip index and a measure of the biggest companies, but leans heavily toward what the stocks with the highest share prices are doing. The S&P 500 tends to more closely follow the entire market. And the Nasdaq tends to be weighted heavily in favor of big technology companies, since those are the kinds of companies that dominate that exchange.

In this video, we understood why market indices are important, how the three most prominent indices work, and what are the differences among them. We hope this video helps you make better investment decisions. Tell us which topics you would like to learn about in the comments!