Explanation of Index Numbers
At the outset, let’s take a look at what index numbers represent. Although there are many different ways to calculate and display index numbers, each index will always measure the change from an original value or base value. The base value of the index is not an accurate measurement of the stock’s value, but is instead considered a weighted average of the prices of all the stocks that make up that index. This index serves as a reference or benchmark used to compare all other changes in value over a specified period of time.
Reading the Indices
When looking at the changes in a particular index, you should consider the following factors:
- Indices do not represent the entire market. Regardless of what happens with the three major indices, focus on your portfolios and the value of your stocks. Pick any day when the three indices are in decline, and you will still see some stocks reaching new highs on the same day.
- Indices react in response to actual trades. If you are listening to financial news, you might think that indices move in response to emotions. It’s easy to be drawn into the hype or affected by market fluctuations. Even smart investors may feel the urge to make trades based on good or bad news. However, the movement of indices requires actual trades, not just assumptions or investor sentiments. Unless you are a rare type of day trader, the narrow view of index changes day to day or hour by hour or minute by minute is not a useful way to assess stock value. Instead, it’s a good way to waste precious time.
- Indices are not designed for quick predictions. What they can do is provide a sense of historical context and past performance. When displayed over a long period of time, they may help you identify patterns and explore trends.
Advantages and Disadvantages of Using Indices
Once you get used to reading the index, you won’t have any trouble getting the information you are looking for and ignoring the rest. But if you are new to the market, it’s easy to be drawn to rapid changes. A lot of information in numerical format can seem confusing. Indices have a lot to offer, but they are not without flaws. Here are some things to keep in mind when reading indices.
Advantages:
- They can reveal investment trends.
- They provide quick snapshots of market activity.
- A standardized way to measure and compare performance.
Disadvantages:
- Human error.
- Errors can accumulate on top of each other.
- Linked to company size.
The Three Major Indices
There are many indices worldwide that provide financial information about specific countries, regions, or sectors, with many offering information on global markets. Here are the most famous, along with the market sectors they cover.
Dow Jones Industrial Average (DJIA)
The Dow Jones Industrial Average is the oldest and most famous index. It is often considered a measure of the market. Initially, the Dow was a simple average of the stock prices in the index, but due to stock splits and other transactions, the index now requires a more complex calculation of the average price. The Dow currently includes 30 stocks. These stocks represent some of the largest and most influential companies in the United States.
The Dow is the only major index that is price-weighted, meaning that if a stock’s price changes by $1, it affects the index by the same amount, regardless of the percentage change in the stock. In other words, a $1 change in the value of a $30 stock has the same impact as a $1 change in the value of a $60 stock.
The calculation of the Dow takes into account many stock splits over the years. If you know how to adjust the math, it is possible to maintain a historically applicable index.
Represent the
The Dow stocks account for about a quarter of the total market value, so from this perspective, it is an expressive signal. Significant changes in the Dow can indicate high investor confidence in stocks. However, remember that due to its composition, it does not represent the investment outlook for any small or medium-sized companies.
S&P 500 Index
The S&P 500 Index is the most commonly used index by financial professionals as the closest representation of the real market. It includes 500 of the most traded stocks and tends to skew towards large companies. This index covers about 82% of the total market value, so from this perspective, it is a better measure of the real market than the Dow. The S&P 500 Index is correlated with market capitalization, as are most other major indices.
NASDAQ Stock Market Index
The NASDAQ Stock Market Index includes all the stocks listed on the NASDAQ market, which has over 2,900 companies. Despite its comprehensive coverage, NASDAQ tends to skew towards technology companies. It is also a market-capitalization-weighted index and, therefore, is significantly influenced by very large technology companies.
Other Indices
There are many other indices that measure larger or smaller segments of the market. Investors in mutual funds can also find funds that track nearly any index they desire. However, the three main indices mentioned above will serve most investors well. If you wish to consider other indices for comparison, be sure you have a good understanding of how each index is structured. Most, if not all, will be correlated with market capitalization. You should also know how to select the stocks contained in the index.
The Balance does not provide tax, investment, financial, or advice. Information is provided without regard to the investment objectives, risk tolerance, or financial situation of any specific investor and may not be suitable for all investors. Past performance is not indicative of future results. Investing involves risks, including the risk of losing capital.
Source: https://www.thebalancemoney.com/what-market-indexes-tell-us-3141365
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