Never forget these two axioms:
Money frees us, but its pursuit may enslave us.
It’s not about how much you have at the end; it’s how much you could have made.
We’re going to take a break from asset classes for one post to talk about what indexes actually are.
Indexes
Let’s start with the biggies.
There’s the S&P 500, the Dow Jones Industrial Average (usually referred to as the “Dow Jones”), and the NASDAQ.
You hear these terms thrown around on the news, articles, etc. all the time with everyone expecting you to know and understand what all of this means. You may know exactly what this all means; you may only know that these words are vaguely related to investing, but you’re not sure what any of these terms actually mean.
What’s what what? What? Huh?
Market Index
The S&P 500, NASDAQ, Dow Jones, Russell 2000, and Wilshire 5000 are all examples of a “market index.” An index provides a summary of an overall collection of stocks by tracking some of the top stocks within that market. They provide (or try to provide) a representative picture that shows the direction (up or down) of where the overall market is going.
Consider them like polls for an election—just taking a representative sample to demonstrate what a larger group is or will be doing.
Indexes definitely don’t track every single stock. Some indexes represent small, medium, and large companies while other indexes represent only the largest companies or only small companies.
Some indexes tend to track companies within a certain sector, like technology, but most are broader.
So what are the most popular market indexes?
The S&P 500
This index tracks 500 large U.S. companies across a wide span of industries and sectors.
The stocks in the S&P 500 represent roughly 70 percent of all the value of all the stocks that are publicly traded (i.e., market capitalization) even though there are over 17,000 traded stocks in the US alone (which tells you how massive and valuable these 500 companies—the ones most everyone has heard of; the Apples, Googles, Facebooks, Fords, and Microsofts of the world— and how tiny and cheap the other 17,000 companies are). (By the way, “S&P” stands for “Standard and Poor’s,” the name of a stock market research firm.)
Companies CAN be (and often are) listed in more than one index. Some of the largest companies within the S&P 500 are also in the Dow Jones Industrial Average.
When people talk about “the market”, as in “How did the market do today?” or “The market is on fire!“, they’re virtually always taking about/referring to the S&P 500 and its performance. The only other possibility is coming up next.
When trying to figure out how your stock, portfolio, or mutual fund/ETF is doing, you’ll be most often using the S&P 500 as your benchmark of comparison.
The Dow Jones Industrial Average (DJIA)
Cool (my idea of cool is probably waay different than yours) fact:
Charles Dow, the editor of the Wall Street Journal actually, created the first index more than a century ago. (The Jones in question is Edward Jones, a statistician and fellow journalist of Dow’s.) In 1896, Dow averaged the stock prices of the top 12 publicly traded companies in the US. (All he did was add their stock prices of the top 12 publicly traded companies in the US together and divided that total by 12, the number of stocks.)
By doing this, he found that he could trace the movement of the overall market, including the average movement of stocks that weren’t included in his index. Sure, some stocks move opposite of the index, but not by much (usually) and they were the exception. (You have to be spectacularly talented (and not in a great way) to lose money when the index in question is up and you have to be spectacularly talented (in a great way!) to make money when the index in question is down.
That’s far from how it’s done now.
The “Industrial” in the Dow Jones Industrial Average is largely historical referring back to the heavy industries of the early 20th century. Many of the modern 30 component companies (It’s now 30 companies in the Dow rather than the original 12 which is why you’ll hear about the “Dow 30” occasionally) have little or nothing to do with true industry or traditional manufacturing. It is also not only the largest (however that is defined) companies in the US on it necessarily any more. For example, Google and Facebook aren’t on the DJIA…at least for now.
Also, the average is what is known as price-weighted, and to compensate for the effects of stock splits and other adjustments, it is currently done as a scaled average.
Dr. Unwise: Um, what now?
Price weighted is easy to explain.
PWT: 30 companies=100% of the DJIA, right?
Dr. Scared: Yes!
PWT: Therefore, each company~3.3% of the DJIA, right?
Dr. Scared: Yes!
PWT: Wrong.
Dr. Scared: Oh God, kill me now!
PWT: Relax. The DJIA just takes into account the stock price of each company. Therefore, a $100 stock will have ten times the influence on the DJIA as a $10 stock and 100 times more influence than a $1 stock.
Dr. Unwise: Makes sense. That’s great. Easy to understand too. That’s it, right?
PWT: No, sadly, like they used to tell us in med school and training, that was the easy part.
Dr. Scared: Oh God, kill me now!
Scaled average is a statistical method to even out disparate entities that are all under one umbrella.
In other words, the value of the Dow (i.e., the number that people are saying on the news when they say “The Dow closed at…. today” or “Today, the Dow reached an all time high of ….”) is no longer the actual average of the prices of its component stocks like when it first began, but rather the sum of the component prices divided by a divisor, which changes whenever one of the component stocks has a stock split or stock dividend, so as to generate a consistent value for the index.
Whether one stock is spitting out quarterly dividends, another is splitting, and yet another is doing neither, the DJIA’s value reflects the sum of all these disparate company’s stocks. Otherwise, without the Dow divisor, dividends and, especially stock splits (remember, for example, if having 100 shares of a $100 stock for a total value of $10,000 is split 2:1, then you have 200 shares at $50 still valued at $10,000), would markedly alter the Dow’s reported number without actually changing its true value.
Currently the divisor is less than one, therefore the value of the DJIA is actually larger than the sum of the component prices.
SR: Hmm, sounds fishy. Like some real Wall street flim flam there.
PWT: Not really. Not this time. But don’t worry. There’s plenty of flim flam going on in Wall
Street and Washington—often one because of the other. This just isn’t it though.
The Dow divisor has fluctuated significantly over the years. In 1928, it was 16.67. Since most big company actions (e.g., stock splits, spin offs, etc.) push the Dow divisor lower, it should be no surprise that the divisor is now microscopic compared to its 1928 value which it is.
Drum roll please…
The Dow divisor as of 12/18/17 (the day I’m writing this) is 0.14523396877348.
Unlike mathematicians, the Dow Jones clearly doesn’t believe in the rule of significant digits given it has a divisor that is currently 14 digits beyond the decimal point.
SR: Jones! Pffft…Some statistician he is!
The Dow Jones Industrial Average (DJIA or the Dow Jones or just “the Dow”) was comprised of the 30 largest U.S. companies. (This isn’t true per se now depending on how you define company size—number of employees, sales, revenue, market capitalization, etc.)
This means the DJIA is constantly shuffling companies in and out as their values rise and fall. They drop and add new companies every so often (every 2-3 years as of late). The components of the DJIA have changed 51 times since its beginning in May 26, 1896.
Only one company on the original Dow Jones list of companies in 1896 still exists on today’s Dow Jones. Any guesses?*
Just for kicks, here are the current Dow 30 (another name used for the DJIA) companies:
3M Company
Caterpillar Inc.
Nike, Inc.
American Express Company
The Goldman Sachs Group, Inc.
Pfizer Inc.
Apple Inc. (added in March 2015 replacing AT&T which was dropped then)
The Home Depot, Inc.
The Procter & Gamble Company
The Boeing Company
Intel Corporation
The Travelers Companies, Inc.
General Electric Company
International Business Machines Corporation AKA IBM
UnitedHealth Group Incorporated
Chevron Corporation
Johnson & Johnson
United Technologies Corporation
Cisco Systems, Inc.
JPMorgan Chase & Co.
Verizon Communications Inc.
The Coca-Cola Company
McDonald’s Corporation
Visa Inc.
E.I. du Pont de Nemours & Company AKA Dupont
Merck & Co., Inc.
Wal-Mart Stores, Inc.
Exxon Mobil Corporation
Microsoft Corporation
The Walt Disney Company
The DJIA along with the S&P 500 are widely accepted as the leading indicators of the health of the stock market. If someone is talking about “the market”, the DJIA or S&P 500 is what they’re likely using as their measuring stick to make any remarks or generalizations about “the market.”
The Wilshire 5000
A lesser known, but still important, index represents up to 5,000 companies of all shapes and sizes, from gigantic corporations to the smallest of small companies. (In industry terminology, these are known as “large cap,” “mid-cap” and “small-cap.”)
The Wilshire 5000 is often called the “total market index.” Despite how representative this index is of the entire stock market, it oddly isn’t nearly as popular or as followed as the DJIA and S&P 500 which I’ve never quite understood.
The Russell 2000
The Dow Jones focuses on large companies, but the Russell 2000 does the opposite: it follows only the tiniest companies. This index tracks 2,000 of the smallest corporations in the stock market.
If you’re either brain addled or a statistician obsessed with number needed to treat and you think that 2,000 companies is too small of a sample size, and you’re seeking for a larger, more representative snapshot of how small-cap companies are faring, you’re in luck. You can gaze upon the Russell 3000, the sister index to the Russell 2000.
The NASDAQ (the acronym for the National Association of Securities Dealers Automated Quotations)
This is one of the three big indexes, but I saved it for last as it can get a little confusing.
“NASDAQ” refers to both an index and a trading exchange.
Dr. Unwise: Uh…What now?
Dr. Scared: Oh God, kill me now!
OK, let’s back up and get a little back story here.
There’s a marketplace where people go to buy stocks just like you (or people you know because I’ve actually never done this even once in my life) buy produce at a farmer’s market. This marketplace is called an “exchange.” The most famous one in the world that all the movies and news programs show is the New York Stock Exchange (NYSE). There’s another famous one also in New York City (they’re actually only 7 minutes apart and represent over $30 trillion—that’s Trillion with a capital T or $30,000 billion or $30 million million if that is even comprehensible) called the Nasdaq Exchange.
Stocks that are traded on the Nasdaq Exchange tend to be tech companies, like Apple Amazon, Facebook, and Google, but you don’t have to be a tech company to be on it (Starbucks is traded in the Nasdaq as is Steve Madden, the shoe company, for example) nor all tech companies traded in the Nasdaq exchange. Twitter, for example, is traded on the NYSE.
SR: Ha! Twitter is a terrible example. It may not even be around by the time you post this to the World Wide Web!
Of course, companies on the Nasdaq or NYSE don’t have to be as huge as Apple, Facebook, or Google. In fact, most of the companies listed in either exchange are much, much smaller.
You’ve likely never heard as many sell only to other businesses and not consumers like you and me.
The Nasdaq is just disproportionately heavy in tech stocks and will surge up or bounce down when something (good or bad) happens in the tech world.
The Nasdaq market index, which is known as the “Nasdaq Composite” or just the “Nasdaq”, tracks the roughly 3,000 companies that are traded on the Nasdaq Exchange by having 100 companies (mostly, but not all tech) in it to mimic what all of them are doing on any given hour of any trading day. (Very, very clever, stock people.)
This is peculiarly unique because no other exchange has its own popular index. The news doesn’t reel off closing highs or lows of the day from the “New York Stock Exchange Composite” mostly because it doesn’t exist. #fakenews
(Of note, this is a market capitalization weight based index which means that 100 companies aren’t each 1% of the index, but rather the bigger they are, the more percent of the index they are. These massive (almost always) tech companies have an outsized influence on the Nasdaq Composite. For example, if Google, Facebook, Apple, Amazon, and Netflix zoom up one day while most of the other 100 companies in the Nasdaq Composite edge down, then guess what? The index still moves up because the big boys have spoken. As companies decrease or increase in value, their share of the index and influence on it will fluctuate accordingly.)
The Nasdaq Composite has grown popular because it’s commonly accepted as a shortcut to understanding how the biggest tech-sector and some other innovative companies – both big and small – are performing financially. And since tech is the tail that wags the dog, everyone wants to hear what the NASDAQ is up to.
Much more on stock exchanges in a future post.
I think we’ve all had enough for one post.
Sorry for going suuuper long on this one, but there was a lot of super important stuff that was all interrelated here that I thought was best to go over all at once.
Sorry if you disagree.
Read it again or as many times as you need to or in bits and pieces. You’re all smart. You know how you best learn, so go and ahead and do it your way at your pace.
I’d love to hear from any and all of you about your thoughts, so we can all learn from one another.
Talk to you soon.
*General Electric is the only company that survived all 121 years on the DJIA list.
Well, not exactly.
GE was removed from the DJIA in September 1897 and came back in November 1907. It’s been on the DJIA since then.
And for you history buffs out there, below are the original dozen companies in the 1896 Dow Jones Industrial Average.
1.) American Cotton Oil Company, a predecessor company to Bestfoods which is now part of Unilever.
2.) American Sugar Company which became Domino Sugar in 1900 which is now Domino Foods, Inc.
3.) American Tobacco Company which is now broken up in a 1911 antitrust action.
4.) Chicago Gas Company which was bought by Peoples Gas Light in 1897 which has since become a subsidiary of Integrys Energy Group.
5.) Distilling & Cattle Feeding Company is now Millennium Chemicals
6.) Laclede Gas Company is still in operation as Spire Inc., but was the first company permanently removed from the Dow Jones Industrial Average all the way back in 1899
7.) National Lead Company, now NL Industries, which was removed from the Dow Jones Industrial Average twenty years after its inception in 1916.
8.) North American Company (boffo marketing division, guys), a holding company for electric utilities, was broken up by the U.S. Securities and Exchange Commission (SEC) in 1946.
9.) Tennessee Coal, Iron and Railroad Company was bought by U.S. Steel in 1907 which was removed from the Dow Jones Industrial Average in 1991—pretty great run!
10.) U.S. Leather Company was dissolved in 1952 because of jerks like you with your faux leather belts and whatnot (especially the whatnot)
11.) United States Rubber Company which changed its name to Uniroyal in 1961, then merged with B.F. Goodrich (a privately held company—i.e., a company that you can’t buy stock in) in 1986 which was then bought out by Michelin in 1990.
12.) Good ol’ GE as previously mentioned