Purpose of Indexes in the Stock Market

Purpose of Indexes in the Stock Market
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Stock market indexes provide investors and money managers with a consolidated view of how the market is performing. The different indexes measure the performance of the broad market or specific sectors and industries. Recent, new stock market products have make indexes even more important to investors.


A stock index measures the price changes of a specified group of stocks. Indexes are most often used as benchmarks against which investors and money managers can measure their own investment performance. The broad range of different stock market indexes can also help investors find sectors in the market that are performing better or worse than the overall stock market. Stock indexes are updated constantly throughout the trading day to provide instant information, and they provide historical data on the market going back decades.


The most widely followed U.S. stock market indexes are the Dow Jones Industrial Average, the S&P 500 and the NADSAQ Composite. The DJIA is composed of 30 of the largest, best-known companies as selected by the Dow Jones Company. The S&P 500 consists of the 500 largest U.S. companies by market value. The NASDAQ index is composed of all of the almost 3,000 stocks listed on the NASDAQ stock market.


Stock indexes are commonly calculated in one of two ways. Market cap weighting gives the more valuable companies a proportionally greater value of the index. The S&P 500 is a market cap weighted index. Price-weighted indexes give the stocks with the higher share prices more weight. The Dow Jones Industrial Average is a price-weighted index. There is also a broad range of indexes that are more focused than the major market indexes. There are sector indexes that may cover sectors such as energy or tech stocks. International stock indexes cover global regions or specific countries.


The rapid growth of exchange traded funds, or ETFs, starting in the late 1990s made stock indexes even more significant. ETFs are not actively managed and each fund holds the components and tracks a specific index. The result is that investors can buy ETFs that mirror the performance of indexes like the Dow Jones Industrial Average or S&P 500. The ETF industry has also pushed the development of many new stock indexes with the specific purpose of carving out an investment sector for an ETF to match.


Charles Dow created the Dow Jones Industrial Average in 1896 so stock investors could track the value of the stock market. Before that time investors were more interested in the stable values of bond investing. The advent of stock indexes allowed investors to track the value of the markets and expanded interest in stock investing. The first ETF, the SPDR S&P 500, symbol SPY, was created in 1993 and allowed investors to participate directly in the values of different stock market indexes.