If you’re one of the 15% of newbie investors who got their feet wet with investing in the stock market in 2020, there are a lot of ins and outs of the stock market you’re probably getting your head around.
But there’s a much smaller number of broad market indicators, called indexes, that you can use to measure the overall performance of the market. What’s more, you can invest in these same indexes to build a low-cost, diversified portfolio.
These indexes “cover the majority of the companies that are publicly traded, and cover companies with large capitalizations, small capitalizations, mid capitalizations,” says Omar Aguilar, a managing director and chief investment officer of investment strategies at Schwab Asset Management.
Here’s how you can use market indexes to track the stock market:
What Does it Mean When Indexes are Up?
When you hear on the news that “the market is up,” or “the Dow Jones jumps 300 points,” it is usually referring to one of the major indexes followed in the U.S.— the S&P 500, the Nasdaq Composite, or the Dow Jones Industrial Average (DJIA).
In a nutshell, when indexes are up, that means the companies included in that index are growing in value.
“Different indexes are comprised of different stocks based on their respective methodology and screening criteria,” says Danqin Fan, a CFP, CPA, and the wealth planning lead advisor of Austin Asset. “Understanding the composition of an index is very important when using it as a benchmark for comparison.” Besides the composition, it’s important to look at the weighted value of each company in an index.
Fan explains further: the S&P 500 index, Dow Jones Industrial Average, and Nasdaq Composite all represent large portions of the U.S. stock market, but vary significantly from one to the next. “Comparing an apple with an orange would not be appropriate or relevant, and the same can be said for market indexes,” she says.
When looking at the performance of market indexes, it’s better to look at the percentage change versus the nominal value, or how many points [the index] went up or down, explains Fan. “Because [the indexes] all have very different nominal numbers or values assigned to them, and every day those values fluctuate,” says Fan. “So it doesn’t really make sense when you say, ‘the S&P 500 is at 4,600 points.’”
A change in percentage would be more meaningful because a 700-point change out of 4,000 versus 700 points out of 36,000 could indicate dramatically different scales of movement.
Broad Market Indexes
Let’s look at some of the broad market indexes:
Dow Jones Industrial Average: Probably the most well-known and widely used index, the DJIA tracks the stock performance of 30 of the largest, most well-known companies.
Dow Jones Wilshire 5000: The Wilshire tracks all the companies that are listed and actively traded on a U.S. stock market, and spans companies of all sizes and industries.
Russell 2000: The Russell 2000 tracks 2,000 small-company stocks. In the realm of small companies, it serves as a benchmark.
The S&P 500 and the Dow Jones tend to be the best indicators of how the stock market is doing as a whole, says Aguilar. “Most people look at them now to represent the broad market.”
Barclays Capital Aggregate Bond Index: This is a fixed income index that is a combination of several bond indexes to track the entire bond market.
When using broad market indexes, keep in mind that not all companies are weighted or represented equally. The majority of these broad market indexes are calculated based on a company’s market capitalization, or the total value of its issued stocks, explains Aguilar. In turn, there is a significant amount of exposure to the bigger companies in the U.S.
“The reality is that the majority of the performance of these indexes tend to be driven by the top ten or top 20 holdings,” says Aguilar. “So while you still have a significant amount of exposure on many securities, a lot of those depend on most of the companies that are at the top of the list.”
While we talked about the most cited broad market indexes, let’s remember there are 5,000 indexes that track different segments, sizes, and types of companies. So depending on what types of investments are in your portfolio, a broad market index may not mirror your own investments or be spot-on with their performance.
How Should You Invest
Bottom line: diversification is the key to investing. It can help you mitigate risks, and typically help your investments grow over time. You can get diversification by investing in ETFs and index funds, which are based on these indexes.
“The primary objective of index funds and ETFs is to replicate the performance and the characteristics of these indexes in a way that is low-cost and efficient for investors,” says Aguilar. In other words, you can potentially own the entire market—or broad segments of it—with just a single cheap investment vehicle.