When news anchors say "the market was up today," they are usually talking about a market index. Indexes are essential tools for understanding overall market performance and are the foundation of index investing. Let us explore how they work.
What is a Market Index?
A market index is a measurement of a section of the stock market. It tracks the performance of a group of stocks that represent a particular market or sector. Think of it as a scorecard for a basket of stocks.
Key concept: You cannot directly invest in an index. Instead, you buy index funds or ETFs that track the index by holding the same stocks in the same proportions.
Indexes serve several purposes:
- Benchmarking: Compare your portfolio performance to the market
- Market sentiment: Gauge overall investor confidence
- Economic indicators: Track economic health
- Investment vehicles: Index funds and ETFs track these indexes
The S&P 500
The S&P 500 is the most widely followed stock market index in the world. It tracks 500 of the largest US companies.
Key facts:
- Contains approximately 500 large-cap US stocks
- Weighted by market capitalization (bigger companies have more influence)
- Represents about 80% of the total US stock market value
- Managed by S&P Dow Jones Indices
- Companies must meet profitability and liquidity requirements
Top holdings (subject to change):
- Apple
- Microsoft
- Amazon
- NVIDIA
- Alphabet (Google)
- Meta (Facebook)
- Tesla
Market Cap Weighting Example
Apple, with a $3 trillion market cap, represents about 7% of the S&P 500. A smaller company in the index might represent only 0.01%. This means Apple's stock movement has 700 times more impact on the index than that smaller company.
The Dow Jones Industrial Average
The Dow Jones Industrial Average (DJIA or "the Dow") is the oldest and most recognized US index, though not the most representative.
Key facts:
- Contains only 30 stocks
- Price-weighted (higher-priced stocks have more influence)
- Focuses on established blue-chip companies
- Created in 1896 by Charles Dow
- Excludes transportation and utility companies (they have their own Dow indexes)
Notable Dow components:
- Apple
- Microsoft
- Goldman Sachs
- UnitedHealth
- Home Depot
- McDonald's
- Boeing
Price-weighting quirk: In a price-weighted index, a $300 stock has three times the influence of a $100 stock, regardless of company size. This makes the Dow less representative of actual market performance than the S&P 500.
The NASDAQ Composite
The NASDAQ Composite tracks all stocks listed on the NASDAQ exchange, making it heavily weighted toward technology companies.
Key facts:
- Contains over 3,000 stocks
- Market-cap weighted
- Heavy technology focus (about 50% tech stocks)
- More volatile than the S&P 500
- Includes many growth and tech companies
Major components:
- Apple
- Microsoft
- Amazon
- NVIDIA
- Meta
- Alphabet
- Tesla
There is also the NASDAQ-100, which tracks the 100 largest non-financial companies on NASDAQ and is a popular trading and investing vehicle.
Other Important US Indexes
Russell 2000
Tracks 2,000 small-cap US stocks. The main benchmark for small company performance. More volatile than large-cap indexes.
Russell 1000
The 1,000 largest US stocks. Combines large-cap and mid-cap companies.
Wilshire 5000
The broadest US index, attempting to track all publicly traded US stocks. Despite its name, it now contains around 3,500 stocks.
S&P MidCap 400
Tracks 400 mid-cap US companies. Fills the gap between the S&P 500 and small-cap indexes.
Global Market Indexes
Major stock markets around the world have their own indexes:
- FTSE 100 (UK): 100 largest companies on the London Stock Exchange
- DAX (Germany): 40 largest German companies
- Nikkei 225 (Japan): 225 companies on the Tokyo Stock Exchange
- Hang Seng (Hong Kong): Largest companies in Hong Kong
- Shanghai Composite (China): All stocks on the Shanghai exchange
Global indexes:
- MSCI World: Large and mid-cap stocks across 23 developed countries
- MSCI Emerging Markets: Stocks in developing economies
- MSCI ACWI: All Country World Index, combining developed and emerging markets
How Indexes Are Calculated
Indexes use different weighting methods:
Market-cap weighted (most common)
Larger companies have proportionally more influence. Used by S&P 500, NASDAQ, and most modern indexes. Reflects how most investors actually experience the market.
Price weighted
Higher-priced stocks have more influence. Used by Dow Jones. A quirky historical approach that can produce misleading signals.
Equal weighted
Every stock has the same influence regardless of size. Gives small companies equal weight to giants. Some investors prefer equal-weight S&P 500 funds.
Index Funds and ETFs
You cannot buy an index directly, but you can buy funds that track them:
Index mutual funds
- Trade once per day at closing price
- Low expense ratios
- Examples: Vanguard 500 Index Fund (VFIAX), Fidelity 500 Index (FXAIX)
Exchange-traded funds (ETFs)
- Trade throughout the day like stocks
- Often even lower expense ratios
- Examples: SPY (S&P 500), QQQ (NASDAQ 100), IWM (Russell 2000)
Popular Index ETFs
SPY: Tracks S&P 500, largest ETF by assets
VOO: Vanguard's S&P 500 ETF, lowest cost
QQQ: Tracks NASDAQ 100, tech-heavy
DIA: Tracks Dow Jones Industrial Average
IWM: Tracks Russell 2000 small caps
Using Indexes in Your Investing
Here is how to use indexes effectively:
Benchmark your performance
Compare your returns to an appropriate index. If you invest in large US stocks, compare to the S&P 500. If you beat the index, you are adding value. If not, consider index investing.
Understand market conditions
When the S&P 500 is up, most large stocks are doing well. When the Russell 2000 outperforms the S&P 500, small caps are leading. These relationships help you understand market dynamics.
Diversify easily
One S&P 500 ETF gives you instant exposure to 500 companies. This diversification is hard to achieve buying individual stocks.
Reduce costs
Index funds have very low fees (often 0.03-0.10% annually) compared to actively managed funds (often 0.5-1.5%).
Compare Your Performance to the Market
Pro Trader Dashboard tracks your trades and compares your performance against major indexes. See if you are beating the market or if index investing might work better for you.
Summary
Market indexes measure the performance of groups of stocks. The S&P 500 is the most important benchmark for US large-cap stocks, while the Dow Jones is historic but less representative. The NASDAQ focuses on technology. Index funds and ETFs let you invest in these indexes with low costs and instant diversification. Understanding indexes helps you benchmark performance and make better investment decisions.
Want to learn more? Read our guide on sector rotation or learn about stock exchanges.