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Constructing the Major Indexes
One Market, Three Perspectives
The best-known stock market indexes — including the Standard & Poor’s 500, Dow Jones industrial average and NASDAQ-100 — get a lot of attention in a bull market. They get even more when the markets turn bearish. That’s because their movements are convenient shorthand for investor sentiment and what’s happening in the economy.
Although these indexes tend to move in the same general direction at the same time, they measure the market in different ways. To understand the differences among them, you need to look at three elements: the stocks that the index includes, how those stocks are selected and the way the index components are weighted.
This index follows 500 large-company U.S. stocks selected from 10 sectors of the economy. The list includes all the country’s major corporations plus others whose names you may not recognize. The component companies are chosen by an eight-person index committee, whose members evaluate individual stocks eligible for inclusion based on a published set of criteria. The committee’s goal is to make the index representative of the economy as a whole, and it modifies the list regularly throughout the year, though not on an official schedule.
The S&P 500 is weighted by market capitalization. This means the largest companies — determined by multiplying the market price times the number of floating shares — exert the most influence on how the index moves during the trading day.
Proponents of this approach maintain that market capitalization provides the most accurate reading of the market because the largest companies have the greatest impact on the economy. Critics contend this approach can yield a skewed reading if the biggest companies in the index are performing one way but the majority of the components are performing another way.
The Dow tracks 30 large-company U.S. stocks — generally the ones that are referred to as “blue chips” — and is probably the most widely known and frequently quoted index. The editors of The Wall Street Journal select the component companies, and they decide when to make a change. Sometimes several years elapse between updates, and they’re rarely dramatic. In 1999, however, the DJIA added Microsoft, Intel and Home Depot to the list of primarily manufacturing and energy stocks to reflect the changing face of the U.S. economy.
Changes in the DJIA’s level are determined by the fluctuating prices of the index components. Since the DJIA is price-weighted, major price movements of the most expensive stocks have a greater impact than a comparable dollar change in a lower-priced component.
The index is composed of the 100 largest nonfinancial companies listed on the Nasdaq Stock Market. The index components are drawn from a number of industry groups, such as biotechnology, retail and wholesale trade, telecoms, and computer hardware and software. The companies are chosen based on their market capitalization from among those that are eligible based on published criteria. Unlike the S&P 500 and DJIA, the NASDAQ-100 tracks international as well as U.S. companies.
The list of companies is generally reviewed annually, and more frequently in unusual circumstances. There’s a similar, though somewhat different, set of criteria for continued inclusion in the NASDAQ-100. As a result, some companies that might not qualify for initial inclusion may be kept in the index. This approach differs from the one followed by the Russell family of indexes, where inclusion or replacement is determined strictly by mathematical calculation.
The NASDAQ-100 uses a modified market-capitalization weighting system. Weightings are reviewed each quarter and any adjustments are based on a proprietary algorithm. The goal is to prevent a single company or small group of companies from exerting too much influence on the index’s movement.
Beyond the Obvious
Whether a market index is up or down at the end of the trading day may be all you want to know. But market indexes provide more than a moment-by-moment report on changing market sentiment. They also capture the market’s history, which lets you compare the present to the past. Although the past can’t predict the future, it can — and does — provide a context for thinking about what might occur.
Virginia B. Morris is the Editorial Director for Lightbulb Press.