Investment Basics: A look at the major stock indexes

September 15, 2006

What's in a name, and a number, when it comes to tracking your investments.

At the top of the radio or TV business news, the announcer will invariably give the performance of the Dow, the S&P 500, and the Nasdaq. And when the Dow drops more than 100 points in a single day, it makes big news. But do you know what it all means, how one index differs from another and which matters most?

Anyone who's invested in the stock market should understand the basics of the primary indexes. There are more than 300 US stock indexes sliced and diced according to company size, business sector, and many more criteria, but we're going to focus on an overview of the most commonly cited benchmarks. First, let's start with the granddaddy of them all, the one that's certainly the most widely quoted . . .

The Dow Jones Industrial Average

"If the Dow is up, the overall market is generally up," says Paul Lohrey, a principal in Vanguard's Quantitative Equity Group. "It's a bellwether that provides a snapshot of the market, and even though there are just 30 stocks, diversification is generally sufficient to prevent a dramatic jump if, say, one of the companies gets a big contract."

The companies that comprise the index are selected by a panel of editors at The Wall Street Journal, which is owned and published by Dow Jones & Co. Although adjustments are made to prevent any one company from exerting undo influence, the actual composition of the index is relatively stagnant, and companies are listed and de-listed only every few years. In 2004, for example, AIG, Pfizer, and Verizon replaced AT&T, Eastman Kodak, and International Paper; the last change prior to that took place in 1999. As such, it's fair to call it the least managed of the major indexes.

Standard & Poor's 500 Index

The S&P 500 is the premier index of widely held large-cap companies. First created in 1923, the original S&P index consisted of 233 companies, but was broadened to 500 in 1957. Its components are about 90 percent large-cap companies (including the Dow 30) and represent a wide sweep of the economy: 21 percent financial firms, 15 percent information technology, 12 percent healthcare, 12 percent industrials; energy, consumer staples, utilities, and more.

The S&P 500 is used as a barometer when comparing the performance of large-cap mutual funds, and large-cap stocks in general. "The index represents the primary pillars of the economy, and an investment in the S&P 500 can be seen as a vote of confidence in corporate America," says Dow Jones' MarketWatch columnist Paul B. Farrell, author of The Lazy Person's Guide to Investing.

The S&P 500 is far more broadly diversified across industries and sectors than the Dow. It currently includes household names like Wal-Mart, Apple, and Merrill Lynch-as well as lesser-known companies like Bemis, Xilinx and Torchmark (packaging, semiconductor, and insurance companies, respectively). However, these two primary indexes are calculated-and, in turn, viewed-very differently. The Dow is a "price-weighted" index, so a stock priced at $100 a share has twice the weighting of one trading at $50. As such, if a company decides to split its stock, the new lower stock price will reduce a company's influence on the index, even if there were no other changes in the company. The S&P 500, however, is "market cap-weighted," meaning each stock's price is multiplied by the number of shares outstanding, to determine how heavily the company is weighted in the index. Therefore, a stock split wouldn't affect anything.