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 has changed over the decades, the concept of an index is as important as ever. In the last three 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. But they all fall into two major camps: market cap-weighted and price-weighted.
Here are some of the most popular stock market indices:
S&P 500 (SPX)
Known as the Standard & Poor's 500, it is a market-value weighted index. Since 1957, it has tracked the 500 largest companies listed on U.S. stock exchanges. The S&P 500 offers asset allocation across many sectors, but large-cap companies make up the bulk of the index’s holdings.
Dow Jones Industrial Average (DJIA)
The DJIA is 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 exchange-traded funds (ETFs) — the Invesco QQQ. The market index places a strong emphasis on large-cap tech stocks.
Russel 2000 Index (RUT)
The Russell 2000 Index is a small-cap stock market index tracking over 2,000 companies. Since 1984, this index has been one of the most common benchmarks for mutual funds.
Value Line Composite Index (VALUE)
Launched by the Kansas City Board of Trade in 1982, it has two 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 the S&P 500.
TSX Composite Index (TSX)
TSX is 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 is made up of 40 major German companies listed on the Frankfurt Stock Exchange. These companies are blue-chip stocks that tend to be less risky than their growth-oriented counterparts.
Nikkei Stock Average (NI225)
A price-weighted stock market index of the Tokyo Stock Exchange, the NI226 has operated since 1950. It consists of the largest 225 Japanese publicly owned companies.
Why Compare Stock Indices?
Between reading market sentiment and 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 is 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. Stock investors should use other metrics in conjunction with market indices, but they are a great starting point.
Track the 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 the market performance, you will quickly know whether it outperformed, underperformed or moved in line with the market.
Stock investors can benefit from comparing stocks with related market indexes. For instance, it may be a good idea to compare tech companies against the market performance of the Nasdaq-100. But the Russell 2000 Index may be a better gauge when assessing the returns of small-cap stocks.
Improve Your Macro Research
Indices can be significant leading indicators. For example, the 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 two 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 via index investing or another strategy to save yourself some time. This realization can help you grow your retirement portfolio and achieve long-term financial goals.
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, the Nikkei fell 0.8%. Even after a one-week delay, when trading resumed after 9/11, the S&P 500 fell 7.1%.
These moves are not predictable, but market reaction gives you valuable data for risk management.
Benzinga’s Best Online Stock Brokers
Stock indices eventually created ETFs, the leading choice for low-cost passive investing. Yet, investing in them is hard without choosing a quality broker. Check our recommendations in the comparison table below.
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
How do you compare stock indices?
Investors can compare indices based on their asset allocations, total returns, performance during recessions and other factors.
What is the best-performing stock index?
The Nasdaq Composite Index has been the best-performing stock index over the past 20 years. Investors should also consider index fund expense ratios to assess how fees will impact their total returns.
Can investors outperform stock indexes?
Investors can outperform market indices, but the odds are against them. Index investing is a simpler path for investors who don’t want to spend as much time analyzing the stock market and its opportunities.
About Stjepan Kalinic
Forex, Equity Analysis, and Financial Education