We always hear about the price of stock markets rising and falling, but have you ever actually considered what is meant by the price of the stock market? Have you ever looked into the various stock indexes that exist? Did you ever consider that there are many that represent the overall global economy? If you’re feeling a little overwhelmed, that is completely fine. We’re here to guide you through the different types of stock indexes that exist, teach you about what they measure and discuss the most popular ones in the United States.
What are stock indexes and why do they exist?
A stock index essentially reflects the value of the overall market or a particular sector of it. As we briefly mentioned, there are many stock indexes. Each one contains an assortment of company stocks which meet certain conditions associated with a given index. The price of a stock index can be used for a few of the following reasons:
To describe past, current and future markets. Since the price of a stock index reflects the overall market performance, any trends in its performance can indicate the state of the economy. Two popular terms refer to bull and bear markets. Bull markets are upwards trending markets, whereas bear markets are downward trending markets.
To gain a better understanding of investor sentiment. Stock prices are set by investors’ future expectations regarding a company’s cash flows. Therefore, the overall stock index essentially reflects how investors feel about the overall market. Bull markets typically reflect optimism, while bear markets reflect pessimism.
To compare returns of specific investments. Often, financial professionals will benchmark portfolio performance against the overall market. This is a particularly useful benchmark since nowadays, exchange-traded funds (ETFs) exist that match movements in the overall market – like the S&P 500 for example. Thus, if your portfolio underperforms the market it means you would have been better off investing in an ETF that reflects the overall market. Instead, your current selection of securities underperformed the overall market performance – in other words, you left money on the table.
Weighted versus unweighted stock indexes.
When discussing the various types of stock indexes, the very first distinction to make is whether it is weighted or unweighted. When it comes to weighted indexes, the magnitude of a particular stock’s value is correlated to its influence on the overall index price. As for unweighted indexes, each stock is treated equally and has equal influence on the total index price. Be sure to note that the majority of stock indexes are weighted, as it is rare to come across one that is unweighted.
What are the different types of weighted indexes?
When discussing the types of weighted stock indexes, there are two kinds that you should be aware of. Each one weighs the importance of a stock based on a specific measure – these being its price and market capitalization (market cap for short).
Price-weighted index: In a price-weighted index, companies are weighted based on the magnitude of their stock price. This means that fluctuations in higher priced stocks tend to have a greater impact on the overall index price, as compared to lower priced stocks. Generally, to calculate the overall price of a price-weighted index, you add up each individual stock price and divide it by the number of companies included in that particular index.
Capitalization-weighted index: A capitalization-weighted index can also be referred to as a market-value-weighted index. Essentially, this type of index weights companies based on its market cap. The market cap can be found by multiplying the number of outstanding shares by the price per share. It then goes that companies with greater market caps will have greater influence in the overall index, as compared to those with lower market caps. For example, consider a situation where there are two companies with differing market caps, but each one experiences a price change of the same magnitude. Here we will see that the company with a greater market cap will have a greater effect on the overall index price as opposed to the one with the smaller market cap. This is the result despite an equal drop in the magnitude of each one’s share price.
The top stock market indexes in the US.
Now that you understand the purpose of a stock index and the many types that exist, let’s get into the specifics. Here are the most popular US stock indexes that are commonly discussed in the investment world.
The NASDAQ Composite Index: Commonly referred to as the NASDAQ, it is known for being heavily populated with tech stocks. Although, this index does include stocks from other sectors, such as finance, industrial, transportation and insurance-related companies. It is a capitalization-weighted index that primarily reflects performance in the tech industry.
The Dow Jones Industrial Average (DJIA): The Dow Jones is one of the oldest stock indexes and well-known to many. It contains the 30 largest and most influential corporations in the US. The price of this index is determined using price-weighted techniques. However, the calculation of the index price has become more complex over the years. Specifically, it is more difficult to calculate than by simply adding up all the stock prices and dividing by the number of companies. The DJIA is said to represent about one quarter of the total US economy.
The S&P 500: The S&P 500 is the most popular index to reference when addressing the overall US economy. It is a capitalization-weighted index that is larger and more diverse than the Dow Jones as it includes a more diverse selection of industries. Comprised of the 500 most heavily traded US stocks, it reflects about 80% of the total value of US stocks. However, there is another index which is an even more precise measure of the total US economy.
The Wilshire 5000: When we said there is an even more accurate measure of the US economy, we were referring to the Wilshire 5000. This capitalization-weighted index contains the listings of all public corporations in the US or with headquarters in the US. It is sometimes referred to as the total stock market index because it essentially reflects the entire US stock market. However, the S&P 500 still tends to be more popular when traders discuss the US economy as a whole.
This just skims the surface of what’s left to explore within each stock index. As you’ve likely realized by now, each one contains a select assortment of stocks that you can trade. Get ready to level the stock market playing field once you know what the professional traders know. Be sure to learn all the ways Elite Legacy Education can help you reach your goals.
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