An Introduction to U.S. Stock Market Indexes

Stock market indexes around the world are powerful indicators for global and country-specific economies. In the United States the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite are the three most broadly followed indexes by both the media and investors. In addition to these three indexes there are approximately 5,000 others that make up the U.S. equity market.

With so many indexes, the U.S. market has a wide range of methodologies and categorizations that can serve a broad range of purposes. The media most often reports on the direction of the top three indexes regularly throughout the day with key news items serving as contributors and detractors. Investment managers use indexes as benchmarks for performance reporting. Meanwhile, investors of all types use indexes as performance proxies and allocation guides. Indexes also form the basis for passive index investing often done primarily through exchange-traded funds that track indexes specifically.

Overall, an understanding of how market indexes are constructed and utilized can help to add meaning and clarity for a wide variety of investing avenues. Below we elaborate on the three most followed U.S. indexes, the Wilshire 5000 which includes all the stocks across the entire U.S. stock market, and a roundup of some of the other most notable indexes.

The Standard & Poor's 500 Index (known commonly as the S&P 500) is an index with 500 of the top companies in the U.S. Stocks are chosen for the index primarily by capitalization but the constituent committee also considers other factors including liquidity, public float, sector classification, financial viability, and trading history. The S&P 500 Index represents approximately 80% of the total value of the U.S. stock market. In general, the S&P 500 Index gives a good indication of movement in the U.S. market as a whole.

Indexes are usually market weighted or price weighted. The S&P 500 Index is a market weighted index (also referred to as capitalization weighted). Therefore, every stock in the index is represented in proportion to its total market capitalization. In other words, if the total market value of all 500 companies in the S&P 500 drops by 10%, the value of the index also drops by 10%.

The Dow Jones Industrial Average (DJIA) is one of the oldest, most well-known and most frequently used indexes in the world. It includes the stocks of 30 of the largest and most influential companies in the United States. The DJIA is a price-weighted index. It was originally computed by totaling the per-share price of the stocks of each company in the index and dividing this sum by the number of companies. Unfortunately, the index is no longer this simple to calculate. Over the years, stock splits, spin-offs, and other events have resulted in changes in the divisor (a numerical value computed by Dow Jones used to calculate the level of the DJIA) making it a very small number (less than 0.2).

The DJIA represents about a quarter of the value of the entire U.S. stock market, but a percent change in the Dow should not be interpreted as a definite indication that the entire market has dropped by the same percent. This is because of the Dow's price-weighted function. The basic problem is that a $1 change in the price of a $120 stock in the index will have a greater effect on the DJIA than a $1 change in the price of a $20 stock although the higher-priced stock may have changed by only 0.8% and the other by 5%.

A change in the Dow represents changes in investors' expectations of the earnings and risks of the large companies included in the index. Because the general attitude toward large-cap stocks often differs from the attitude toward small-cap stocks, international stocks, or technology stocks, the Dow should not be used to represent sentiment in other areas of the marketplace. In general, the Dow is known for its listing of the U.S. markets best blue-chip companies with regularly consistent dividends. Therefore, while not necessarily a representation of the broad market, it can be a representation of the blue-chip, dividend-value market.

Most investors know that the Nasdaq is the exchange on which technology stocks are traded. The Nasdaq Composite Index is a market-capitalization-weighted index of all the stocks traded on the Nasdaq stock exchange. This index includes some companies that are not based in the United States.

Known for being heavily tech weighted, this index includes several subsectors across the tech market including software, biotech, semiconductors, and more. Although this index is known for its large portion of technology stocks, it does include some securities from other industries as well. Investors will also find securities from a variety of sectors as well, including financials, industrials, insurance, and transportation stocks, among other. The Nasdaq Composite includes large and small firms, but unlike the Dow and the S&P 500, it also includes many speculative companies with small market capitalizations. Consequently, its movement generally indicates the performance of the technology industry as well as investors' attitudes toward more speculative stocks.

The Wilshire 5000 is sometimes called the "total stock market index" or "total market index" because it includes all of the publicly traded companies with headquarters in the United States that have readily available price data. Finalized in 1974, this index represents the entire U.S. stock market and its movement aggregately. Although it is a very comprehensive measure of the entire U.S. market, the Wilshire 5000 is referred to less often than the more popular S&P 500 Index.

Generally, there are a few ways to look at indexes broadly. Capitalization is often key, with indexes falling into either large, mid, or small-cap buckets. The S&P 500 and Dow Jones Industrial Average are two of the top large-cap indexes but others include the S&P 100, the Dow Jones U.S. Large-Cap Total Stock Market Index, the MSCI USA Large-Cap Index, and the Russell 1000. Notable mid-cap indexes include the S&P Mid-Cap 400, the Russell Midcap, and the Wilshire US Mid-Cap Index. In small-caps the Russell 2000 is an index of the 2,000 smallest stocks from the Russell 3000. Other popular small-cap indexes include the S&P 600, the Dow Jones Small-Cap Growth Total Stock Market Index, and the Dow Jones Small-Cap Value Total Stock Market Index.

Investors also commonly look to sectors with Standard & Poor’s leading in this realm of the market. Standard & Poor’s manages: the S&P Communication Services Select Sector, S&P Consumer Discretionary Select Sector, S&P Consumer Staples Select Sector, S&P Energy Select Sector, S&P Financial Select Sector, S&P Health Care Select Sector, S&P Industrial Select Sector, S&P Materials Select Sector, S&P Real Estate Select Sector, S&P Technology Select Sector, and the S&P Utilities Select Sector. These indexes represent the S&P 500’s comprehensive sector segregations.

The growth of smart beta index investing has also helped to increase the number of indexes in the market. Smart beta indexes are passive indexes that are built using certain characteristic or fundamental screens that help to improve the quality of index constitution. Advisors Asset Management (AAM) has three smart beta index funds in the market that largely encompass the entire global market for dividend and value investing. AAM’s smart beta index funds include the AAM S&P 500 High Dividend Value ETF (SPDV), the AAM S&P Developed Markets High Dividend Value ETF (DMDV), and the AAM S&P Emerging Markets High Dividend Value ETF (EEMD).

Indexes play an important part in the overall analysis of the U.S. equity market. Indexes and their movements provide a great deal of insight into the economy, the investing public’s risk appetite, and the trends for investing diversification. In general, understanding the nuances of their construction and composition can be essential for making all types of investment decisions.