If you pay attention to the news, you probably hear about “the Dow,” “the Nasdaq” and “the S&P;” quite frequently. These are the nicknames of three of the most widely followed stock indices. They’re quoted at the top of almost every financial website and scroll across the bottom of the screen of cable news channels. Each index has different characteristics and represents a different piece of the stock market.
About Stock Indices
A stock index tracks the prices of certain stocks, called components. Each index selects its components based on various criteria, such as company size or industry. It uses a formula to generate an index value that it quotes in points and that fluctuates with its components’ market prices. For example, if the prices of the Dow’s component stocks rise in general, the Dow might increase by 100 points.
Dow Jones Industrial Average
Although the Dow Jones Industrial Average follows the smallest number of stocks of these three indices, it is the oldest and most well known. It tracks the prices of 30 large U.S. industrial companies that play a big role in the U.S. economy. Unlike the Nasdaq and the S&P;, the Dow is a price-weighted index -- stocks with higher prices influence its value more than those with lower prices. In the Dow’s calculation, a $90 component stock has more impact than, say, a $15 stock.
Nasdaq Composite Index
The Nasdaq Composite Index follows the highest number of stocks out of these three indices – more than 3,000, as of 2012. It includes all the common stocks and similar types of investments listed on the Nasdaq stock market, many of which are technology, or “tech,” stocks. Similar to the S&P;, the Nasdaq weights its index value by company size. This means that a company with a higher market value, or capitalization, influences the index more than one with a lower market cap.
Standard & Poor’s 500
The Nasdaq might track more companies, and the Dow might be better known, but the S&P; 500 provides a broader representation of the overall U.S. stock market. This index’s components consist of 500 large, highly influential U.S. companies that encompass about 75 percent of the U.S. stock market’s value, as of 2012. Like the Nasdaq, larger companies pull more weight in the index’s value. For instance, a price change in a $50 billion company affects the index more than that of a $5 billion company.
Investors use these indices to monitor the performance of the overall stock market and as a benchmark to compare with their own investments' performance. For example, if the S&P; rises 10 percent while your stock portfolio jumps 15 percent, you outperformed the market. You can also buy index mutual funds and exchange-traded funds that closely mimic the performance of an index. These investments provide the same diversification as owning all the stocks in an index.
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