Investing is a great thing and a very useful skill to possess. If you’re lucky, you can make thousands of dollars in a matter of years. In order for that to happen, you need lots of knowledge and experience and obtaining it is well worthwhile. Hence, the more you know, the more apt you’ll be in understanding the world of investment, even if there are facets of it that you never plan on exploring. Likewise, understanding who the various indices are and how they work will enable you to make more informed decisions when applying your skills in the stock market.
First of all, you need to know what an index is. An index represent the measurement of the true worth of a sector within the stock market. It is calculated from the prices of selected stocks, or more accurately termed as a weighted average. Used by financial managers and investors, an index serves as a description of the market as a whole. It also compare the returns on selected investments.
But how is it used in investing?
- Provides a quick snapshot of equity market activity.
- Is a useful performance benchmark for investors.
- Forms the underlining for many derivatives contracts.
A second vital term to understand is market capitalization or market cap for short. It refers to the total value of all the company’s shares. Investors use market cap to measure the size of a business and its worth.
Market cap equals the total number of outstanding shares of a company multiplied by its market value.
This lets investors know how much the company’s shares are worth on the open market. For example, if the ABC Corp had 100,000 outstanding shares priced at $10 apiece, it’s market cap would be $1,000,000. Here is the list of the most common marketplace indices:
- Dow Jones
- S&P 500
- FTSE 100
1. Dow Jones
Dow Jones is a stock index company that tracks financial information and publishes it to the Wall Street Journal. It is often termed as a barometer of the US stock market, but it only tracks 30 stocks within the entire country. – The Dow Jones Industrial Average
The Dow Jones Industrial Average (DJIA) is a stock market index made up of 30 American companies that have been around for a long time It can be thought of as a snapshot of how the US market is performing in a given day. The DJIA is shown on a second by second basis throughout each day that the market is open: 9:30 am to 4:00 pm eastern time. There is a double-digit number that represents the DIJA on a slow day and a triple-digit number on a regular or active day. It is presented in green when it goes up and red when it goes down.
2. S&P 500
The S&P 500 is a stock or index created by a firm known as Standard & Poors. It is also termed as a market index that represents a composition of 500 different US stocks which were selected by analysts and economists employed by this firm. These 500 stocks are the most watched stocks in the entire US market. The S&P 500’s index committee strives to include the 500 most followed US companies in its index. This selection changes overtime since the analysts and economists want only the top 500 to be included.
If a company within the index loses its worth or desirable, it is simply replaced with one that is worthy of investing in. Keep in mind that businesses are not swapped out often. For example, if a particular entity files for bankruptcy, it will then be replaced with a financially sound company. This index merely represents the US stock market as a whole. On the other hand, the DJIA is composed of only 30 entities. Since this is true, the S&P 500 has more exposure to the stock market, it paints a more accurate picture US stocks in general. Hence, the performance of mutual fund managers, well-known investors, or investment records in their entirety is always compared to the S&P 500. Mutual funds portfolios then compare their results with this market index. It is known that 75% of mutual funds fail to beat the results of the S&P 500.
3. FTSE 100
The FTSE 100 (short for Financial Times Stock Exchange) is an index which measures the top 101 Britain companies tracked every 15 seconds on the London Stock Exchange (LSE).
Why are there 101 stocks?
This is because Shell is listed twice: as Shell ROSA and ROSB. During its inception in 1984, the market capitalization (the cost of all the shares added up) of the UK’s top 100 companies was converted into 1,000 points or £100 billion. The FTSE 250 measures the next 250 companies immediately below the top 100 and the FTSE 350 equals the FTSE 100 and FTSE 250 combined. To break it down, the FTSE contains oil and mining companies, the banking system, consumer goods, and technology. Examples of entities included in the FTSE are:
- Royal Dutch Shell, BP
- Lloyds, HSBC, Barclays, Standard Chartered, RBS
- Imperial Tobacco and British American Tobacco
- Tesco, Morrison’s, Sainsbury, M&S
The FTSE is calculated by taking the free float market cap and dividing it by the index divisor. The free float market cap represents the sum of the value of publicly traded shares.
The NYSE (New York Stock Exchange) is a stock exchange entity located in New York City. Globally, it is the biggest equities-based exchange derived from the market cap of its listed securities. Up to 2005, it was a privately run institution. That year it acquired the Archipelago electronic trading exchange. For many decades, the NYSE was limited to floor trading only as a stock auctioning site.
Presently, most NYSE trade are done electronically even though floor traders are needed to establish pricing and work in high volume institutional trading. Public trading can be done at its physical location, Monday through Friday from 9:30 am to 4:00 pm. Likewise, it is not open on major holidays and may close early on rare occasions.
NASDAQ (the National Association of Security Dealers Automated Quotations) is an index that was created to enable dealers to post their quotes electronically. Today, it is the main competitor to the NYSE. It was established to increase the trading of over-the-counter stocks that did not meet the requirements of to have these stocks listed on larger indices as the NYSE. Before NASDAQ, such stocks were traded mainly over the phone and because information pertaining to the stock had to be obtained from a dealer who specialized in the stock, it was difficult for the public to trade these stocks.
It was founded in 1971 to streamline trading to the entire investing market. This new market achieved instant success and in 1975, the NASDAQ released its own set of trading requirements merely to segregate larger companies from smaller ones that have been traded over-the-counter up to then.
The NASDAQ aimed to have its index able to compete with larger indices as the NYSE. While the NYSE is still the largest stock exchange to in market capitalization, the success of the NASDAQ all electronic model has allowed it grow to be the exchange in trading volume.
– The NASDAQ Versus the NYSE
Again, the NASDAQ and the NYSE are two leading competitors in the stock exchange market. However, there are major differences between the two organizations:
- While the NYSE has a physical location (in New York City) the NASDAQ does not.
- One does quoting entirely different from the other. While the NYSE is a public auction type site where attendees trade stocks with one-another, the NASDAQ is a dealer market where buyers and seller trade with a market maker. A market maker is one who works at a registered broker dealer and promotes trading by posting a price in the market that they’re willing to make a trade in, known as the bid price as well as the price they’re willing to sell at, known as the author price.
- The NYSE uses specialists while the NASDAQ uses market makers. The difference between the two that the specialists aims to match existing buy and sell orders in an orderly manner where they strive to create a market by posting their own buy and sell orders. Market makers compete for your order and by doing so, this helps keep transaction costs down.
So now you have a brief description of the five major trading indexes and how they work.
Again they are the:
- S&P 500
- Dow Jones
- FTSE 100
An index is a group of selected stocks whose averaged out values give a snapshot of how well the investment market is doing. The market cap is a number that represents a company’s true market value. These are handy aids when it comes to choosing stocks. Understanding indexes is vital when making trades in the marketplace. To become even more well-versed in investing, you may want to learn more about each index. The more you know about them, the better investment decisions you can make down the road.