The U.S. stock market has such broad dimensions that grouping businesses that share similar characteristics was the only way to ensure efficient monitoring of the overall picture.
And that's why several indices have been created that essentially group firms by their industry or sector type, or in some cases by their sheer size, i.e., market capitalization.
These indices serve a range of purposes, and the most pertinent of these, perhaps, is as an explainer of how a particular set of companies are performing. The media also uses stock indices to report how the economy is faring – the idea being that if the major indices are performing well, it's excellent news for the American economy.
Given that more and more people are turning to the stock market for a passive income stream – especially the self-employed impacted by the pandemic – these indices are a crucial part of planning your financial future.
Indices can be used as benchmarks too – which stocks are performing better or worse than the rest of their index?
What you need to know
In the United States, there are three powerful indices: the Nasdaq, the S&P 500, and the Dow Jones. There is also the Wilshire, which offers a sort of composite look at 5000 of the biggest companies on American soil.
The point of each index is to offer an overall look and feel of how U.S. businesses are performing. They shouldn't be taken as the only measure, as firms can under or outperform their index, and investors do take them with a pinch of salt.
The leading indices are either market or price-weighted. Market weighted indices see each stock represented proportionally to its total market capitalization. If the value of all the firms in an index drops 5%, you will see that the index is 5% in the red.
As the name suggests, price-weighted indices are slightly more fluid and are impacted by a change in the price of their major companies. So, if a $100 stock drops 5%, that is a more considerable loss to the index than a $10 share that drops 5% – essentially, more value is lost in the former case than the latter.
One of the advantages of eToro and brokers like it is that you can trade the individual companies within an index or the index itself – if you feel that tech firms will have a strong quarter, for example, you might want to invest in the Nasdaq.
So, what do you need to know about the main indices?
As the name suggests, the Nasdaq index only covers those firms whose stocks are listed on the Nasdaq exchange.
Generally focusing on big tech companies, the Nasdaq is a composite look at their performance over a given timeframe.
Popular sub-sectors of the Nasdaq that investors like to explore include software, biotechnology, video streaming platforms, payment channels, and so on.
The Nasdaq is a market-weighted index.
The S&P 500
The S&P 500, or the Standard & Poor's index to give it its full name, reflects the performance of 500 of the biggest companies in America.
Firms are typically selected for the S&P 500 based on their market capitalization, financial viability, and overall trading history. A management committee selects the firms listed on the S&P 500, with ‘rebalancing' events held quarterly.
Generally considered an excellent guide as to how the overall stock market in the United States is performing, given that it accounts for around 80% of the market's total value.
The Dow Jones
The Dow Jones is only concerned with the ‘big boys' – major blue-chip companies that are the most valuable in America.
Sometimes known as the DJIA, the Dow Jones is one of the most frequently used indices in the world and is typically considered an excellent barometer for the U.S. market as a whole.
While only accounting for around 25% of the overall value of the market, it's notable that firms of all sizes and industries tend to fall in line with the performance of the Dow Jones.
The DJIA uses a price-weighted methodology to calculate the value of its stocks, so the most valuable firms tend to have more impact on the overall value of the index.
The Wilshire 5000
While a lesser-used index than the trio above, the Wilshire 5000 essentially offers a market-wide view of all the stocks listed in the United States.
Often known as the ‘total stock market index,' all publicly traded companies with a headquarters listed as being in the U.S. feature on the Wilshire.
Around for nearly five decades, the Wilshire offers investors a very quick look at how the overall market is performing – all those with specific areas of interest will use the other indices as their primary measure of when to buy and sell.