Wondering how “the market” did today?
When American investors refer to “the market” or “the stock market,” they’re usually referring to one of the three major U.S. stock exchanges: the Dow Jones, the Nasdaq, and the S&P 500. Or all three.
But these indexes represent different stocks and market segments, so you should understand the differences before investing in stocks.
The Dow Jones Industrial Average
The oldest U.S. stock exchange, the Dow Jones Industrial Average — or the DJIA, Dow, or Dow Jones for short — began in 1896 as a way to track the 12 largest industrial companies of the era.
Today the Dow includes 30 blue-chip companies ranging from Microsoft to Coca Cola to Disney, and the index features all industries except for utilities and transportation. These market sectors have their own separate Dow Jones indexes.
The DJIA doesn’t swap in or out companies often, and the criteria remains vague. Aside from being some of the largest companies in the country, the companies are expected to be leaders in their industry. A committee meets periodically to vote on keeping or replacing members of the index.
Stocks in the Dow Jones are weighted by price, so stocks with higher prices make up a greater percentage of the total index. If a $100 stock rises by $10, and a $5 stock also rises by $10, both changes are weighted equally, even though that jump in price represents a much larger leap in value for the $5 stock.
The Dow offers some insight into how the nation’s largest companies are performing. But with only 30 companies, it hardly represents the U.S. stock market as a whole. The price weighting also distorts the index’s performance, as a company’s share price tells you less than its market capitalization (market cap).
Take the index’s movements with a grain of salt, and consider it more of an ultra-high cap bellwether rather than a definitive statement about U.S. stock trends.
The S&P 500
The S&P 500 index includes 500 U.S. companies rather than only 30, making it a broader indicator of U.S. large cap stocks. These companies include Alphabet (Google), 3M, Allstate, Amazon, and Microsoft. Note that companies can appear in multiple stock indexes, as Microsoft does.
The number of companies included in the S&P has changed over time. Going back to 1927, the S&P has returned around 10% per year on average. That includes an era when the index only included 90 companies, before expanding to 500 in 1957.
Like the Dow, the stocks making up the S&P 500 are determined by a committee. As of 2021, companies must have a market cap of at least $13.1 billion, have positive earnings for at least the last four quarters, maintain adequate liquidity based on price and trading volume, and at least 50% of shares must be owned by the public (known as public float).
Unlike the Dow, the S&P 500 is weighted by market cap rather than price. Market capitalization includes the total value of all a company’s shares: the share price multiplied by the number of outstanding shares.
Imagine a company with shares priced at $1,000, but which only has 100 shares in circulation, for a total market cap of $100,000. In contrast, another company has 1 million shares in circulation, but each share is worth only $10, for a total market cap of $10 million. Which company has a higher market value? The one with a market cap of $10 million of course, which is why the S&P 500 weights by market cap rather than stock price.
The S&P 500 offers a broader picture of how U.S. stocks are trending. Even so, the index represents the largest U.S. companies, and tells you nothing of how smaller companies have performed.
The Nasdaq Composite
First and foremost, understand that the Nasdaq is a stock exchange, and was in fact the first completely electronic stock exchange. The Nasdaq Composite is the stock index, which includes over 3,000 of the companies traded on the Nasdaq. The index includes all companies with common stock trading on the Nasdaq, but excludes preferred stock, exchange-traded funds (ETFs), and other types of securities.
While investors tend to think of the Nasdaq as an exchange for technology stocks, stocks from all market sectors trade on the Nasdaq. Even so, the Nasdaq Composite index does disproportionately feature tech stocks.
Example companies listed on the Nasdaq include Apple, Microsoft, Netflix, Tesla, and Intel. Many investors and pundits use the Nasdaq Composite as a barometer for the technology sector as a whole, even though it includes many non-tech companies (such as PepsiCo).
Like the S&P 500, the Nasdaq Composite is weighted by market capitalization.
Don’t confuse the Nasdaq Composite — which includes nearly every stock that trades on the Nasdaq — with the Nasdaq 100. The latter includes just 100 of the largest non-financial stocks that trade on the Nasdaq, such as Starbucks, Adobe, and Amazon.
Which Index Should You Follow?
As a broad measure of the U.S. stock market, the S&P 500 serves as the most representative index. It includes companies in every industry, and is weighted by market cap. Even so, it includes only large-cap companies.
For a more tech-oriented weathervane, follow the Nasdaq Composite’s movements. If you want a glimpse into small-cap stocks, check the Russell 2000.
The Dow Jones may get the most attention from reporters, but it actually represents the U.S. market least well of the three major indexes. The sample size is too small, and being price-weighted further distorts its value.
Final Word
The three major stock indexes above only represent U.S. stocks, not international companies.
For more global exposure, you can explore foreign stock market indexes such as the S&P Europe 350 Index or the Dow Jones Asian Titans 50 Index.
Better yet, save yourself the stress and don’t bother following the stock market’s movements at all. Instead, automate your stock investments with a robo-advisor, and simply dollar-cost average your investments in index funds. Avoid emotional investing by ignoring the daily volatility of the market.
While day traders need to stay glued to their stock tickers, you don’t. The stock market rises and falls, and over the long term it averages a strong upward trend. I sleep easily at night knowing that when it goes up, I enjoy a higher net worth. When it goes down, I get to buy stocks at a discount. No matter what happens, I win — because I participate in the market on autopilot, without letting emotions affect my investment decisions.
Source: moneycrashers.com
