Making heads or tails of the financial news can be difficult. What does it really mean when the market was “up” or “down”? News reports about the stock market that you see or hear every day often report the movement of groups of stocks, and much less so the price movement of an individual company’s stock. “The Dow Jones Industrial Average (DJIA) was up 120 points today” or “the S&P 500 remained relatively flat today” are common vernacular you may hear financial news pundits use. Citing a specific “index” or “average” provides a general sense of the direction of stock prices. They will not, however, tell you whether the stocks in your own portfolio are up or down. Understanding what these reports mean is important since they are commonly used as benchmarks to measure the performance of individual stocks.
Stock indexes and averages are simply ways to measure changes in the market value of certain groups of stocks. An average, as the name implies, is the arithmetic average price of a group of stocks. The DJIA is such an average. Made up of 30 large industrial stocks, the DJIA was originally calculated by adding up the prices of the stocks included in the average and then dividing by 30. This divisor has since been adjusted numerous times to account for mergers, additions, deletions, and other technical factors.
An index on the other hand, is an average value expressed in relation to a previously determined base number. The Standard and Poor’s 500 Index (S&P 500) for example, uses a base value of 10. The total market capitalization of all companies in the S&P 500 (as of 9/10/2020) was approx. $33,391,900,000,000. To make this number more easily reportable, the base value of ten is applied and the number is reported as 3,339.19.
It is also important to understand the components of the most commonly used indexes and averages:
- Standard & Poor’s 500 Index: This index is the benchmark against which many portfolio managers compare themselves and is composed of 500 “blue chip” stocks, separated by industry, so that almost all key industries are represented.
- Dow Jones Industrial Average: The commonly quoted average tracks the price-weighted movement of 30 of the largest blue-chip stocks traded on the New York Stock Exchange (NYSE).
- NASDAQ Composite Index: This index tracks the movement of all companies traded on the NASDAQ National Market System (NMS), which tend to be smaller and more volatile than those in the DJIA or the S&P 500. The NASDAQ Composite is market-value weighted, giving more influence to larger and higher priced stocks.
- Russell 2000 Index: This is the key barometer and indicator of companies on the smaller end of the capitalization spectrum. This domestic “small cap” index is made up of the bottom two-thirds of the Russell 3000 index, a larger index of 3000 publicly traded companies that represent nearly 98% of the investable U.S. stock market.
- MSCI ” EAFE® ” (Europe, Australasia, and the Far East): This market weighted index consists of approximately 1,600 foreign stocks listed on the exchanges of 22 developed countries (excluding the U.S. and Canada) representing all major industry groups.
Index and average tracking can be very useful in comparing the performance of your own portfolio to a specific benchmark average. The validity of the comparison, however, depends on your ability to determine which index serves as the appropriate benchmark for your specific holdings. Please remember, none of these indices are available for direct investment, however, you can purchase mutual funds and exchange traded funds (ETFs) that are designed to mimic a certain index.
Jeff Witz, CFP® welcomes readers’ questions. He can be reached at 800-883-8555 or at firstname.lastname@example.org.
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