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Precisely 137 years ago, on July 3, 1884, Charles Dow created the world’s first stock index, the Dow Jones Transportation Average Index (DJTA).
It was a revolutionary idea at the time. By compiling 11 transportation stocks into a single indicator, anyone could track the market sentiment in real-time.
While DJTA changed over the decades, the concept of an index is as important as ever. In the last 3 decades, it prompted the rise of exchange-traded funds (ETFs) and brought forth the concept of passive investing.
Read on to learn what indices are and how to use them as an investor.
How Many Stock Indices Exist?
An overwhelming number of indices exist around the world. Whether it’s geography, exchange listing, market cap or sector, multiple factors dictate how they are assembled. However, they all fall into 2 major camps: market cap-weighted and price-weighted.
Here are some of the most popular ones:
- S&P 500 (SPX): Known as the Standard and Poor’s 500, it is a market-value weighted index. Since 1957 it has tracked the 500 largest companies listed on stock exchanges in the U.S. Because of the market cap balances, the top 10 holdings account for 26.4% of the index.
- Dow Jones Industrial Average (DJIA): One of the oldest and most followed indices. Since 1885 it has tracked 30 of the most prominent companies listed in the U.S. It is a price-weighted index, meaning that the index contribution depends on the stock price, not the total market cap. Despite its age, it remains an important industrial benchmark.
- Nasdaq-100 (NDX): A stock market index based on the 100 largest nonfinancial companies listed on the Nasdaq stock exchange. Since 2007, it has been the base for one of the most popular ETFs — the Invesco QQQ.
- Russel 2000 (RUT): A small-cap stock market index, tracking 2,035 companies with a median market cap of $922 million. Since 1984, this index has been the most common benchmark for mutual funds.
- Value Line Composite Index (VALUE): Launched by the Kansas City Board of Trade in 1982, it has 2 forms: arithmetic (equal size) and geometric (equal weight). It consists of 1,681 companies listed on the Toronto Stock Exchange (TSX), New York Stock Exchange (NYSE), Nasdaq Stock Market (NASDAQ) and American Stock Exchange (AMEX).
- Wilshire 5000 Total Market Index (W5000FLT): A market-cap-weighted index of all American stocks. Set as a benchmark for the total activity of publicly traded companies headquartered in the U.S.
- Volatility Index (VIX): A popular measure of market volatility, VIX provides the market’s expectation of forward-looking volatility. By taking the VIX value as a percentage and dividing it by the square root of 12, you will get the 30-day implied volatility for S&P 500.
- TSX Composite Index (TSX): The Canadian market benchmark index. With 250 companies, it represents 70% of the Toronto Stock Exchange market cap.
- Deutscher Aktienindex (DAX): The stock market index made from 30 major German companies listed on the Frankfurt Stock Exchange. From the 3rd quarter onward, it will increase to 40 companies while simultaneously tightening regulations.
- Nikkei Stock Average (NI225): A price-weighted stock market index of the Tokyo Stock Exchange. Operating since 1950, it consists of the largest 225 Japanese publicly owned companies.
Why Compare Stock Indices?
Between reading market sentiment to speculating on geopolitical risks, there are several reasons to compare stock indices.
- Assess the overall market sentiment. A picture says a thousand words, and for a stock index, this goes exponential. A single chart can show overall market sentiment for hundreds and sometimes thousands of individual companies. It is a powerful tool to gain a lot of insight with just a glance.
- Track performance of individual securities. Evaluating the performance of a single stock would be impossible without a proper measure. A stock index provides the solution. By comparing the stock with an underlying index, you will quickly know if it outperformed, underperformed or moved in line with the market.
- Improve your macro research. Indices can be significant leading indicators. For example, Baltic Dry Index (BDI) shows the demand for shipping capacity versus the supply of dry bulk carriers. It covers approximately 320,000 in dry bulk deadweight tonnage. Because the cost of ships is high, and it takes 2 years to build a ship, cargo ships’ supply is tight and inelastic. Dry bulk cargo primarily consists of raw materials that serve as production inputs. Because supply is inelastic, demand has a significant influence on price. Therefore, BDI price predicts future economic production.
- Measure the efficiency of your investment. Comparing your portfolio to a basket of indices (stocks, bonds, commodities, real estate) will measure the efficiency of your investments. If you are not outperforming the market as an active investor, it might be better to focus on the passive investing approach and save yourself some time.
Compare Stock Indices Against Current Events
For indices, event-driven moves show the risk appetite of the market.
For example, Brexit caused a 10% drop in the Financial Times Stock Exchange (FTSE) Index in a single day, while the DAX lost 7%. After North Korea’s most powerful nuclear test, Nikkei fell 0.8%. Even after a 1-week delay, when the trading resumed after 9/11, S&P 500 fell 7.1%.
These moves are not predictable, but market reaction gives you valuable data for risk management.
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Everything is Relative Without a Measure
Whether it’s time, distance or stock market returns, you’d be lost without a measure. You would struggle to know where you stand. It would be an unpleasant, time-consuming process.
Stock indices provide a convenient, fast measure. Having all the historical data at your fingertips, makes it easy to evaluate anything. By using individual stocks, sectors or geographical markets, you can easily express yourself in percentages.
Finally, stock indices are a godfather to ETFs — investment vehicles that revolutionized passive investing. These present an excellent opportunity for people who want to invest their money while keeping the cost of time and fees to a minimum.
Frequently Asked Questions
Stock indices can be classified by location (e.g., Nikkei 225), size (e.g., Nasdaq-100) or sector (e.g., Dow Jones Transportation Average).
While the indices often are compared to each other, measuring the relative performance over some time, they are best used to measure individual stock Alpha, which measures the excess return of a security. For example, if Apple gained 15% in a year where S&P 500 gained 10% — it has created 5% Alpha.
Indices are a great way to gauge your portfolio. If your portfolio is down 1% on a day when the broad market is down even more, there is no need to worry. Your portfolio is doing better than most.
When it comes to absolute returns, here are the statistics of some of the most prominent indices over the last 2 decades. If you invested $1,000 in each of these on Jan. 1, 2001, here is how much you’d have today (before fees).
Standard and Poor’s 500 (SPX), $3,134
Nasdaq Composite Index , $6,217
Dow Jones Industrial Average (DJIA), $3,206
TSX Composite Index (TSX), $2,260
Financial Times Stock Exchange 100 Index (FTSE), $1,139
Deutscher Aktienindex (DAX), $2,430
Nikkei 225 (NI225), $2,073
For the last 20 years, the clear winner is the Nasdaq Composite Index, where your investment would have increased 6-fold over the years.