Indices and how they work

An explanation for the financially impaired.

For those of you out there that don’t invest or religiously listen to financial news, you might ask yourself from time to time, what the f*ck is the Dow? If you listen to, read or watch the news, it’s a term that’s hard to avoid. Where the Dow isn’t the whole stock market, it is an indicator as to how the market is doing. The DJIA, or Dow Jones Industrial Average, is just that; a (price-weighted) average of 30 companies (big companies like Microsoft, Disney, and Apple) traded on both the New York Stock Exchange (NYSE) and the Nasdaq. It’s different than the similarly named Dow Jones and Company, who are not only the publishers of the Wall Street Journal, but also the people that maintain the DJIA. Now, before going any further, price-weighted, just means higher priced stocks are given more weight than lower priced stocks because they have a larger influence in the market. The heavier they are weighted, the more they influence the index.

An index is the key to how most people interact with the stock markets. It is a calculation of percentage change in particular markets. So, in a sense, an index is taking an imaginary cross-section of the market, let’s say a hypothetical portfolio, so one can see where it is generally headed (sometimes called ‘tracking the market’). This is how you can have the Dow up, and the Nasdaq down. Both are different and separate indices that provide indications as to what the market is doing, but do not reflect everything going on in those markets. For example, where the Dow might have risen one day last week, my personal portfolio could have been in the red because the Dow doesn’t reflect all stocks in the market.

Back when the Dow was created in 1896, by the appropriately named Charles Dow and Edward Jones, calculating it was as simple as dividing the value of the stocks by the quantity. But now we have splits, an action allowing companies to split stock prices in half while doubling quantity, without the company losing half of its value. To make up for this change in the index, the curators of the DJIA divide the value of the stocks by something called the Dow Divisor—a number that is, as Investopedia states, “continuously adjusted”. This helps maintain accuracy in the DJIA, whereas an unadjusted number would show false drops in both companies’ stock values as well as the whole index if there had been stock splits.

Okay, so now that we’ve addressed the Dow, let’s tackle the Nasdaq. The Nasdaq has one fundamental difference from the Dow; namely, that in addition to being an index, it is also a trading platform. One can trade stocks on the Nasdaq Exchange whereas one can’t trade on the Dow Jones. In addition to these differences, the Nasdaq Composite (the full name for the Nasdaq index) includes about 4,000 stocks and they are all exclusively traded on the Nasdaq exchange.

The last of the major indexes is the S&P 500. The “S&P” part, is for Standard & Poor’s, which is a rating service. In their own words, they provide “high-quality market intelligence in the form of credit ratings, research, and thought leadership” (a quote from the website of Standard & Poor’s).Where the DJIA may have once been considered the best market representation, the S&P has, in some opinions, come to take over that role. In this index 500 stocks are chosen to best reflect the U.S. equities market (another name for the stock market).

So now you have the big picture, what the daily numbers mean. An amazing source for financial knowledge is Investopedia. Not only were they my primary source, but they are an incredible resource for financial terms and concepts. I have frequently used their site to look up terms that are completely foreign to me. Two other good resources are the Planet Money and Marketplace podcasts. The first takes a human approach to explaining big complicated fiscal issues in 20 minute chunks. The latter is a daily update on global issues that affect the economy and a low down on the the daily ‘numbers’.