What Is a Market Index?

What Is a Market Index?

Let me explain what a market index really is. It's essentially a group of stocks or other asset classes designed to track the performance of a specific market segment. You see, a market index is a list of investments that represents a portion of the financial market, with its value calculated from the prices of those listed investments.

Some indexes use market-cap weighting, others revenue weighting, float weighting, or fundamental weighting. Weighting adjusts how much each item impacts the overall index. As an investor, you follow these indexes to gauge market movements. The big three for the U.S. stock market are the Dow Jones Industrial Average (DJIA), S&P 500 Index, and Nasdaq Composite Index.

In the bond world, Bloomberg provides key indexes like the Bloomberg U.S. Aggregate Bond Index, a popular stand-in for U.S. bonds. Remember, you can't invest directly in an index; they're used as benchmarks or to create index funds.

Understanding a Market Index

Diving deeper, a market index measures the value of a portfolio with specific market traits. Each one has its own calculation method, maintained by the provider, usually weighted by price or market cap. You, as an investor, use these to follow markets and manage portfolios.

They're central to investment management—funds benchmark against them for performance, and managers build investable funds from them.

Types of Market Indexes

Every index calculates its value differently, but weighted average math is the core. This means price-weighted indexes shift more with high-priced holdings, while market-cap weighted ones react to changes in the biggest stocks. It all depends on the weighting setup.

Market Indexes As Benchmarks

Indexes serve as benchmarks across finance. Take the Dow Jones, S&P 500, and Nasdaq—they cover the 30 largest U.S. stocks by market cap, the top 500, and all Nasdaq stocks, respectively. These act as proxies for the U.S. market.

Others target niches, like micro-sectors or bond maturities, or geographic areas such as emerging markets or the FTSE 100 for the UK and Europe. You might build a portfolio mixing exposures from various indexes, or use them to allocate based on segment returns. Specific indexes benchmark portfolios or mutual funds.

Index Funds

Fund managers use benchmarks to measure performance, detailed in prospectuses for transparency. These also evaluate manager pay. They create index funds too, since you can't buy an index directly—it's too costly to trade all holdings.

Index funds offer a cheap way to invest in a full index portfolio, replicating most or all constituents. Expenses are low compared to active funds, though some costs remain in the expense ratio.

Why Indexes Matter for Your Investments

You might opt for index investing over single stocks for diversification. A balanced portfolio could split 50% in an S&P 500 ETF and 50% in a U.S. Aggregate Bond Index ETF to optimize returns and risk.

For growth sectors, consider ETFs like iShares Global Clean Energy (ICLN) tracking the S&P Global Clean Energy Index, Reality Shares Nasdaq NexGen Economy (BLCN) for blockchain, or First Trust Nasdaq Artificial Intelligence and Robotics (ROBT) for AI and robotics.

Major Stock Indexes and Their Use

In the U.S., key indexes are the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite. Internationally, there's the FTSE 100 for Britain and Nikkei 225 for Japan.

Indexes give you a quick snapshot of a sector without checking every asset. For tech, the NASDAQ-100 Technology Sector Index shows average trends efficiently.

The Dow is the oldest and most cited U.S. index, but the S&P 500 covers a broader economy slice.

The Bottom Line

Market indexes are curated lists representing market segment performance. Various types exist, and they're used to create index funds, letting you buy a basket of securities instead of individual stocks.