stock market work

How the Stock Market and Its Indexes Work

From graphics on CNN to the iPhone home screen, the numbers of stock indices surround us every day, measuring the value of the stock markets. But what do the numbers actually mean?

Here’s an explanation of three frequently cited indices, the Dow Jones, NASDAQ, and S&P 500.

The Dow Jones Industrial Average (DJIA)

Created in 1896, this index tracks the daily stock market performance of 30 major publicly available companies. The companies are not necessarily the most valuable corporations; instead, they’re chosen by a Dow Jones Committee and are considered leaders in their industry.

Most of the companies in the index are listed on the world’s largest exchange, New York Stock Exchange.

Together, their value is about 25% to 30% of the U.S. stock market across all sectors, Dow Jones says, making them a good indicator for the whole market. Changes in companies are relatively rare, having only occurred 111 times over its 117-year lifespan.

Like all indices, the DJIA works by adding up the price of all its 30 stocks, then dividing by a certain number. The divisor, decided by the Committee, is changed every time a DJIA company has a stock split or dividend. This keeps the value of the index consistent even when a company drastically changes its amount of stock on the market.

The index is also price-weighted. This means that changes in any given stock have a proportional effect on the index based on price. A 1% drop in the value of a $100 stock will have a much larger effect on the index than a 1% drop in a $10 stock.

Some have criticized this methodology, saying the Dow should switch its weighting to market capitalization, multiplying the stock price with the number of stocks available. This would remove the need to change the divisor when stock numbers change, and would reduce the influence of higher-price stocks.

Dow defends price-weighting on its website, however, saying the index would look the same, and that changing the methodology would invalidate historical comparisons.

NASDAQ Composite

This index only includes stocks on the NASDAQ. After NYSE, it’s the second largest stock market in the world, including both U.S. and non-U.S. stock. Many technology companies are listed on the NASDAQ.

The Composite index has tracked the index since it was created in 1971. It currently exists of over 3,000 stocks. Any NASDAQ stock can be listed as long as it fits the eligibility criteria listed by the index.

The NASDAQ Composite is market capitalization-weighted, meaning the value of each company listed is calculated by multiplying the amount of shares available with the last available sale price. The aggregate value of all shares are then divided by a divisor that takes into account daily changes in market value.

The full methodology can be found on NASDAQ’s website.

S&P 500

Choosing from both the NYSE and the NASDAQ, this index lists the 500 leading, publicly traded companies in the U.S.

The S&P is published by the ratings agency Standard & Poor’s, and the companies listed are chosen by a committee employed by the agency.

In addition to requiring a market capitalization – price of stock multiplied by amount of stocks – of over $4 billion, there are seven criteria for being on the index, as listed on the S&P website.

Created in 1957, the index has grown to be a trusted indicator of the U.S. economy as a whole. With a total market cap of almost $15 trillion, the index represents around 75% of the U.S. stock market.

While the index was originally market cap-weighted, it transitioned in 2005 to a float-weighted methodology, meaning it only uses the number of shares publicly available to calculate market capitalization.

Summary

Dow Jones:

  • Consists of 30 companies chosen by committee, rarely changes
  • Lists stocks from any exchange, but most are on the NYSE
  • Created in 1896
  • The average is weighted by the price of individual shares

NASDAQ:

  • Consists of over 3,000 companies, any company on the exchange can be listed
  • Lists only NASDAQ stocks, which are often tech stocks
  • Created in 1971
  • The average is weighted by value of all shares in a company

S&P 500

  • Consists of 500 companies, chosen by committee
  • Lists stocks from both the NYSE and the NASDAQ
  • Created in 1957
  • The average is weighted by the value of publicly tradable shares in a company

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