Reports on indexes and averages can help benchmark stock performance.
Making heads or tails of the financial news can be difficult. What does it really mean when the market was up or down? News reports about the stock market that you see or hear every day often report the movement of groups of stocks, and much less so the price movement of an individual company’s stock. “The Dow Jones Industrial Average (DJIA) was up 120 points today” or “the S&P 500 remained relatively flat today” are common vernacular you may hear financial news pundits use.
Citing a specific index or average provides a general sense of the direction of stock prices. They will not, however, tell you whether the stocks in your own portfolio are up or down. Understanding what these reports mean is important because they are commonly used as benchmarks to measure the performance of individual stocks.
Index vs average
Stock indexes and averages are simply ways to measure changes in the market value of certain groups of stocks. An average, as the name implies, is the arithmetic average price of a group of stocks. The DJIA is such an average. Made up of 30 large industrial stocks, the DJIA was originally calculated by adding up the prices of the stocks included in the average and then dividing by 30. This divisor has been adjusted numerous times to account for mergers, stock splits, and other factors.
An index, on the other hand, is a total value expressed in relation to a previously determined base number. The S&P 500 (formerly known as the Standard and Poor’s 500 index), for example, uses a base value of 10. The total market capitalization of all companies in the S&P 500 is about $33,391,900,000,000 as of September 10, 2020. To make this number more easily reportable, the base value of 10 is applied, and the number is reported as 3,339.19.
It is also important to understand the components of the most commonly used indexes and averages:
S&P 500 Index. This index is the benchmark against which many portfolio managers compare themselves. It consists of 500 blue-chip stocks, separated by industry, so that almost all key industries are represented.
Dow Jones Industrial Average. The commonly quoted average tracks the price-weighted movement of 30 of the largest blue-chip stocks traded on the New York Stock Exchange.
Nasdaq composite. This index tracks the movement of all companies traded on the Nasdaq Stock Market, which tend to be smaller and more volatile than those in the DJIA or the S&P 500. The Nasdaq is market-value weighted, giving more influence to larger and higher-priced stocks.
Russell 2000 Index. This is the key barometer and indicator of companies on the smaller end of the capitalization spectrum. This domestic small-cap index is made up of the bottom two-thirds of the Russell 3000 index, a larger index of 3000 publicly traded companies that represent nearly 98% of the investable US stock market.
MSCI EAFE Index. This market-weighted index consists of about 1600 foreign stocks listed on the exchanges of 22 developed countries (excluding the United States and Canada), representing all major industry groups.
Index and average tracking can be very useful as a comparison against your own portfolio. But a valid comparison depends on your ability to determine which index is the best benchmark for your holdings. Remember, none of these indices is available for direct investment. You can, however, buy mutual funds and exchange traded funds designed to resemble a certain index.
Witz is educational program director at MEDIQUS Asset Advisors, Inc in Chicago, Illinois.
He welcomes readers’ questions and can be reached at 800-883-8555 or email@example.com.
The information in this column is designed to be authoritative. The publisher is not engaged in rendering legal, investment, or tax advice. If you would like assistance with your individual investment strategy, please email firstname.lastname@example.org.