What is a Market Index? The Dow Demystified

If you ever watch the news or read the newspaper, you've heard about the Dow, the NASDAQ and the S&P 500. However, these terms can be mysterious to beginning investors, even those who have a clear grasp of stocks and bonds (if you don't, first read another article in this series, titled "What are Stocks and Bonds?"). Here's a quick explanation of market indices in general, and a brief overview of the major indices.

What is a Market Index?
A market index is simply a way of categorizing different parts of the market and measuring their performance. Since the stock market was born, stock brokerages have been analyzing different stocks and grouping them together in various ways for reporting purposes. These different groups are called indices. The Dow Jones Industrial Index, the NASDAQ and the S&P 500 are all market indices, and while they are the most widely known, there are many, many more out there.

The Dow
The Dow Jones Industrial Average is probably the best known market index around. It was founded as a way to measure the industrial sector of the stock market (hence "Industrial" in the title), but nowadays this index simply tracks and averages the performance of the 30 largest companies in the United States, industrial or no. While most people think of the Dow as the ultimate measure of the stock market's performance, it is actually a rather narrow sample of the entire market.

The S&P 500
Just like the Dow, the S&P 500 is a market index that tracks large companies, but its scope is much broader. The S&P 500 averages the stocks of 500 of the largest companies in the stock market (mostly American companies) and is considered an excellent benchmark for the stock market's performance due to its breadth and diversity.

The NASDAQ
The term "NASDAQ" actually comes from the name of a specialized stock market born in 1971. It was the first fully electronic stock market and the first in the United States to advertise to the public. It is primarily made up of the stocks of technology companies. The NASDAQ that we generally read about these days is actually the NASDAQ Composite Index, which is simply a measure of all of the stocks that trade on the NASDAQ stock market. As previously mentioned, they are mostly technology stocks, which makes the NASDAQ somewhat more specialized than the S&P 500, even though it is made up of over 3000 separate stocks.

Having a clear understanding of market indices can help allay the fears of beginning investors. While a sharp drop in the Dow does indicate distress in the market, it doesn't mean that the sky is falling - it just means that the average value of those 30 stocks is down for the day. Understanding market indices and the sectors of the market that they track can also help investors with another very important task - choosing mutual fund investments. I'll be posting an article titled "What are Mutual Funds?" very soon, to help explain the basics! Remember to check the series introduction for links to all related articles, which will be added as soon as they're published.