A market index is a hypothetical portfolio of investment holdings representing a specific financial market segment. The value of this portfolio can be calculated using the following methods: market-cap weighted, revenue-weighting, floating-weighting, equal weighted, and fundamental-weighting. Investors follow specific indexes as a measure of market movements. The three most popular indexes in the US are Dow Jones Industrial Average, S&P 500, and Nasdaq Composite. I am sure you have heard of these on the news, on any financial dashboard, or a financial podcast. But do you know what they represent?
The Dow Industrial Average, often referred to as Dow Jones or Dow, was launched on May 26, 1896. This index comprises 30 blue chip companies listed on stock exchanges in the United States. The Dow is the oldest and most followed index.
The term blue chip was carried from the game of poker, representing the most valuable chip. In the stock market, blue chip companies refer to companies with a national reputation for quality, reliability, and consistent profitability. These companies are household names like Apple, Verizon, Walmart, and American Express, to name a few. (See complete list) The price of the stock determines the weight of each company.
The higher valued stock would be weighted more than a lower valued stock. It is referred to as a price-weighted index. The list will be rebalanced every quarter and does not include transportation or Utility stocks. These industries have their own index, Dow Jones Utility Average and Dow Jones Utilities Average.
The next one is the Standard & Poor’s 500, commonly known as the S&P 500, was officially introduced on March 4, 1957. This index tracks the stock performance of the 500 largest publicly traded US companies, as measured by market capitalization. The companies with the largest market capitalizations receive the highest allocations, and in turn, the index price movement is driven by its top 10 corporations. (See the latest top 10 stocks in the S&P 500.) It is considered one of the essential benchmark indices for the US stock market, covering an extensive breadth of industry sectors. As a result, some investors believe the S&P 500 is the best gauge of the large US stock market and sometimes the equity market. The S&P 500 rebalanced quarterly, but the committee meets monthly, and intra-quarter changes may occasionally occur. The company’s liquidity, size, and industry are the rebalancing criteria.
The Nasdaq Composite, or simply Nasdaq, is a stock market index with companies listed on the Nasdaq stock exchange and launched in 1971. The index is weighted heavily towards the information technology sector. It is valued using the capitalization-weighted methodology. The Nasdaq contains more than 3,000 stocks listed on the exchange. In addition, some investors will use the Nasdaq 100 large-cap growth index, a subset of the Nasdaq that concentrates on the market capitalization of 100 top domestic and international non-financial companies.
Some companies are part of all three indices, and others belong to only one. A great example of companies that are a member of all three indices is Apple Inc. (AAPL), Microsoft Corporation (MSFT), and Cisco Systems Inc. (CSCO). Other companies that are only listed on the Nasdaq are Airbnb, Inc. (ABNB), Palo Alto Networks Inc. (PANW), and Zoom Video Communications Inc. (ZM). These indices represent a subset of all the publicly traded companies in the US. According to The Global Economy.com, the US shows 4266 listed companies as of 2019.
When comparing your portfolio performance to the overall market, it is essential to determine which index is most appropriate. The Nasdaq Composite will be the most appropriate index if your portfolio is heavily invested in technology stocks. If you are invested in a mix of large and small companies, you may consider using more than one index to reflect the composition of your portfolio. Before you compare your portfolio return with the market, find out how you are invested in comparing apples to apples and find the appropriate benchmark.