Stock indices are benchmarks that are used to gauge the performance of a group of stocks. There are many different types of indices and each of them is unique in its own way. This section will take a look at the major stock indices that investors use and why they use them.
Dow Jones Industrial Average
The Dow Jones Industrial average is by far the most famous of all the stock indices. It is composed of 30 widely traded blue chip stocks (large, well-established companies that are leaders in their respective industries). The 30 stocks are chosen by the editors of the Wall Street Journal (which is published by Dow Jones & Company), a practice that dates back to the beginning of the century. The Dow was officially started by Charles Dow in 1896, at which time it consisted of only 11 stocks.
The Dow is computed using a price-weighted indexing system. Simply put, the editors at WSJ add up the prices of all the stocks and then divide by the number of stocks in the index. (In actuality, the divisor is much higher today in order to account for stock splits that have occurred in the past.) The Dow is highly regarded for its simplicity and its history.
However, there are some disadvantages in using the Dow as a benchmark. First of all, the Dow only includes prices for 30 stocks, yet there are thousands of publicly traded stocks on the market. Critics of the Dow therefore question whether or not the Dow is a representative snapshot of the market as a whole. Another problem with the Dow is that it is weighted by price, instead of market capitalization . So, for example, a stock that trades at $100 but has a market cap of only $1 billion will receive more weight than a stock that trades at $50 but has a market cap of $5 billion. Most experts agree that market capitalization-weighted indices better reflect the market’s performance than price-weighted indexes.
Not surprisingly, the Nasdaq Composite tracks all of the stocks listed on the Nasdaq exchange . The index dates back to 1971, which is when the Nasdaq exchange was first formalized. The index is used mainly to track technology stocks, and thus it is not a good indicator of the market as a whole. Unlike the Dow, the Nasdaq is market capitalization-weighted, so it takes into account the total market value of the companies it tracks and not just their prices. Since the index tracks all of the 5000+ stocks listed on the Nasdaq, it includes more than just a representative sample of the technology industry. Critics charge, however, that the index tracks too many small companies whose performance increases the index’s volatility.