Stock market indexes are a valuable tool for any trader, allowing traders to get a comprehensive view of sectors and markets in order to make educated and informed trading decisions. But what is a stock market index, and how do they work? Read on to find out the essentials on stock market indexes.
What is a stock market index?
A stock market index is a method to track the performance of a group of assets on the stock market in a standardised way, consisting of a compilation of stocks constructed to replicate a particular market, sector, commodity, or anything else an investor might want to track.
Stock market indexes allow investors to broadly track securities as easily as they could track a single stock. When the index drops, that means the stocks within the index are, on average, decreasing in price.
While an index may contain hundreds, even thousands of stocks, they are not all included in the index equally. Each stock in an index has a weighting assigned to it, which determines how the shares in a given index basket are allocated; stocks with higher weightings have more influence on the index’s movements than those with lower weightings.
Types of stock market index that weight stocks differently include:
Price-weighted indexes, which give more weight to companies with higher stock prices
Market-capitalisation-weighted indexes, which give more weight to companies with higher market capitalisations (market capitalisation is the market value of a publicly traded company’s outstanding shares)
Equal-weight indexes, which as the name suggests give equal weight to every stock regardless of market capitalisation, stock prices or any other factors
Examples of stock market indexes
Stock market indexes can be used to track movements on the stock market over a number of different axes, such as across markets, sectors and commodities.
Some major stock market indexes include:
- The Dow Jones, which tracks 30 of the largest and most important US companies
- The S&P 500, which measures the stock performance of 500 large companies listed on stock exchanges in the US
- The Nasdaq Composite, which includes almost all stocks listed on the Nasdaq stock market
Other examples of stock market indexes with different focuses include:
- The Nasdaq 100, which focuses on the largest 100 companies listed on the Nasdaq stock market
- The Russell 2000, which consists of 2,000 small-cap companies listed on the Russell 3000 index
- The Russell 3000, which measures the performance of the 3,000 largest publicly held companies incorporated in America, as measured by total market capitalisation
- The S&P Growth Index, which consists of stocks in the S&P 500 considered to have “growth characteristics,” which are generally companies with above-average sales growth and trade for relatively high price-to-earnings ratios.
- The S&P Value Index, which consists of the stocks in the S&P 500 that are considered to have “value characteristics,” which are generally stocks that trade for relatively low multiples of their book values and earnings, and are typically more mature, slower-growing companies
Pros and cons
Pros:
- Simplifies the research process– Stock market indexes do the heavy lifting for investors who want to learn about how an industry, economy, or sector is performing. Investors can watch a single index rather than having to find relevant companies and study their performance on an individual basis.
- Exposure to commodities– Depending on the sector being tracked by the index, buying stock market indexes may be the only option for an investor looking to expose themselves to certain markets. Instead of dealing with the commodities physically and logistically, these investors can buy the appropriate commodity index that tracks the market they want to buy into.
- Portfolio diversification– Stock market indexes can be used alongside index exchange-traded funds (ETFs) and mutual funds, which makes it easier to diversify your portfolio. Index funds are an easy way to gain exposure to a range of markets and sectors without having to place thousands of orders.
Cons:
- Not always accurate– While an index is designed to emulate a certain market, that doesn’t necessarily mean it’s 100% accurate. Many factors can alter the course of an economy, and it can sometimes be difficult for an index to accurately account for all of those factors.
- Not always liquid– Depending on the index you track, it may be difficult to trade in and out of certain positions. If you’re trading an obscure index, it also may be difficult to find a person willing to buy or sell the security you want to trade. However, this shouldn’t be an issue with indexes that consistently see high daily trading volumes.
- Other trading issues still apply– All the downsides that come with other forms of investing also apply to index investing