What Is an Index? | Simple Steps for a Retirement Portfolio Course

What Is an Index? | Simple Steps for a Retirement Portfolio Course
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    You've likely heard news reporters say things like, The Dow is up 100 points, or The S&P is down five points. But what does that mean? The Dow, S&P 500, and Nasdaq are examples of stock market indices. A stock market index measures the performance of a collection of stocks. By measuring these stocks collectively, indices track how the overall market is performing better than only looking at the performance of a single stock. Think of it this way: if you focus too closely on just one thing, you might not have a good understanding of the larger picture. This is why an index's performance provides more complete information than the performance of individual stocks--indices provide a wider view of the stock market as a whole. The first index was the Dow Jones Industrial Average, published in 1896. Financial reporter Charles Dow added up the closing prices of 12 of the largest stocks at the time and divided the total by 12 to get the average. Today, the Dow consists of 30 of the largest and most successful companies in the U.S. These companies are handpicked by experts to represent a wide variety of industries. Some of these companies affect the average more than others, though, because many indices are weighted. Think of the idea of weighting like grades: a final exam is going to make up a larger portion of your grade than a daily homework assignment. In the Dow, companies with higher prices are given more weight. In 2018, Boeing, the highest priced stock in the index, made up about 9% of the index whereas Pfizer, the least expensive stock, was only 1% of the index. So a change in Boeing's price would have had a greater impact on the Dow than if Pfizer's price changed. While the Dow is the oldest and most well-known index, some believe that its measurement is less representative of the overall market than the S&P 500 even though they often perform similarly to each other. The S&P 500 measures the performance of 500 of the largest publicly traded companies in the U.S. Due to its broader exposure, some believe that the S&P 500 is the best measurement of the U.S. stock market. The S&P 500 is weighted by market cap. Market cap is the number of a company's outstanding shares multiplied by the price per share. Because of this, the companies with the largest total market value have the greatest impact on the average of the S&P 500. The Nasdaq Composite, also referred to as the Nasdaq, includes 3,000 or so companies that are traded on the Nasdaq exchange. The Nasdaq includes more smaller companies than the other indices, but also includes many of the largest tech companies, like Apple, Amazon, Microsoft, and Alphabet. Because nearly half of the companies are tech companies, the Nasdaq is widely considered a better gauge for the Technology industry. Some of these companies may also be included on the Dow, the S&P 500, or both. Each index helps measure how the overall market is doing through the performance of the securities it tracks. Though the market may vary day to day, or even year to year, the historical performances of indices show that over time, the stock market tends to rise.
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