Last Friday, I explained what a stock exchange is in response to a reader’s question. Today, I tackle the second part of his inquiry: what do the numbers in something like the Dow represent?  To phrase it another way, he’s asking what it means when someone says “The Dow closed up 120 points today at 17,759” or the “S&P is down 7 points at 1,800.” Here’s what you need to know.

Definition of an Index

The numbers that appear on your news station or that you hear on the radio are closing numbers for the indexes that track the market as a whole or a specific sector. Like the exchanges, indexes come in a wide variety. The most commonly referenced are the Dow Jones Industrial average (“the Dow”), The S&P 500, and the Nasdaq.

The Dow

The Dow is the oldest (est. 1882) and most widely-known index. It contains a price-weighted average of the 30 largest companies in the US.  A price-weighted average means that the prices of each stock are added together and divided by the total number of stocks. The Dow calculation also takes into account the Dow divisor to compensate for actions such a merging, splitting, or certain stocks dropping out of the index, With this type of average, the securities with a higher price per share have more influence on the index as a whole because they are given more weight. 

The S&P and Nasdaq

The S&P and the Nasdaq indexes, on the other hand, are market-capitalization weighted (the S&P of 500 influential stocks and the Nasdaq of all equities on the Nasdaq exchange). Market capitalization, or market-cap for short, is determined by multiplying the stock price by the amount of outstanding shares.

With these indexes, the higher the market cap, the more effect a change in that stock will have on the index. In other words, a change in Apple stock will have more of an effect on the index, than a change in McDonald’s stock because of its higher market-cap.

Similarly to the Dow, the S&P and Nasdaq use divisors in calculating the figures that we hear about everyday.

Also keep in mind that many other indexes serve as benchmarks for specific sectors. For instance the S&P 600 tracks small-cap companies. The Wilshire 5000 represents the stock of almost all public traded companies in the U.S.  And the MSCI, a global index, includes large companies based all over the world.

Focus on change, not the number

While the Dow is the most widely known index and thought by many people as a barometer for “the market,” most professionals use the S&P 500 to determine how the market is doing. The 30 companies in the Dow only represent about a quarter of the value of the market. Conversely, The S&P accounts for about 70% of the total market. In addition, experts consider the market-cap weighting a better measure of the market’s movement because it’s easier to compare changes in percentages rather than dollars.

However, the important thing isn’t to focus on the number itself but how it has changed. You’re looking to see how the value of the index reflects the growth or decline of that particular sector of the market from the point you invested. You can then compare that growth to the growth of your particular investments.

A History Lesson

A quick history of the S&P 500 will show the correlation between the indexes and the economy a little clearer. It also highlights how you can use the index values to see overall growth of the market by where it has been.

• January 1957: The S&P starts out at 46.20.
• January 1967: Over the next decade it would grow and shrink, but ended up 80.33.
• Economic boom of mid-1980s, 1990s: The economic boom during the mid-1980s and 1990s spurred the growth of the index to an intraday high of 1,552.87 on March 24, 2000.
• October 10, 2002: The dot-com bubble bursts, and the index declines to 768.83.
• October 2007 – The mortgage bubble pushed the S&P as a high as 1,562.47 in October of 2007, but the bubble bursting reduced it back to 679.24 in March of 2009.
• Current day – As the economy and markets have improved from The Great Recession, so has the S&P 500. We are riding a high wave right now with an all-time closing high of 2,130.82 on May 21^st of this year.

The history of the Dow is also very interesting since it has been around for more than a century.

• October 1896: The Dow was first published in the Wall Street Journal in October of 1896 at 40.94, when it included just 12 stocks. It grew to 20 stocks in 1916 and then 30 in October of 1928. That first high was 242.46.
• July 1932: After the Dow became 30 stocks, it grew to 355.63 but then plummeted to 41.08 in July of 1932 during The Great Depression.
• November 1972: It took several decades for the Dow to get back into the 300s, but it rose during the 50s, 60s and 70s, first breaking 1,000 in the November of 1972.
• Dot.com 1980s, 1990s: The Dow exploded during the during the dot-com era of the late 80s and 90s climbing past 11,000 in 2001.
• The Great Recession: The dot-com bubble burst reduced the Dow a bit, but it found its way to 14,000 in 2007. However, the Great Recession cut it in half,  with it bottoming out at 6,594 in March of 2009.
• Current Day: Since then the Dow has rebounded. As the economy has improved, we’ve seen the Dow hit an all-time high of 18,312.39 in May of this year

The Nasdaq Index has had the shortest life span, starting in 1971. It contains mostly technology stocks, but also has some small-cap and non-US stocks.  It’s used more of an indicator of the tech sector because of its composition. You can find a great history of the Nasdaq figures here.

Stay smart and consistent

You can see why we hear about the index numbers every day. People use them as an indicator of whether to be optimistic or pessimistic about the market. They also serve as important benchmarks to how your investments compare to the rest of the market.

The critical point to remember, though, is that the market has had its ups and downs for decades. And it will continue to do so in decades to come. Rather than getting preoccupied by turmoil in the market day-to-day, you should focus on consistently investing and adjusting your asset allocation to fit your time-horizon. This will allow you to benefit from the ups and the downs and grow your money in the best way possible.