Understanding Market Indexes

Most financial news reports will give daily results of a few key financial market indexes. In theory, this provides readers, viewers or listeners an idea of what is going on the financial markets and maybe some insight into their own portfolios. While we think it is okay to keep abreast of what is going on in the financial markets, it is important to understand that the indexes that are most widely reported are very limited in the information they are actually giving us and in most cases not representative of a diversified investment approach.

There are a number of indexes that attempt to measure the performance of the financial markets and serve as a gauge of economic activity.  The following are descriptions of several of the most common:

Dow Jones Industrial Average

The Dow is the most widely recognized and quoted index.  Consisting of only 30 US domiciled stocks, it is generally the narrowest measure of market performance.  Oddly enough, the companies with the highest stock price are given the largest weighting in the index (a stock split would reduce a company’s weighting in the index).  Dividends paid by Dow companies are generally not considered when calculating the performance of this index.

S&P 500

The S&P 500 is the most commonly referenced U.S. equity index and is comprised of the 500 largest U.S. companies.  The S&P 500 is market capitalization weighted, meaning the largest companies constitute the heaviest weightings in the index.  For example, at present, the top 10 stocks in the index constitute a (massive) 29% weighting while the remaining 490 companies constitute a mere 71% weighting.

Russell 2000

The Russell 2000 index is a generally accepted benchmark for the stock performance of small companies - those with market capitalizations of under $5 billion.  The Russell 2000 Index is more evenly weighted than most, as the top 10 holdings represent less than 2% of the index's overall value.

Wilshire 5000

The Wilshire 5000 is considered the “total market index.” It is by most accounts, the best reflection of overall stock market performance.  The index is market cap weighted, meaning that the firms with the highest market value account for a larger portion of the index.  Dividends are generally excluded when calculating the performance of this index.

NASDAQ Composite

The purpose of the Nasdaq Composite index is to gauge the performance of the “highest growth” companies that are listed on the Nasdaq stock exchange. Containing roughly 2,500 companies, the Nasdaq Composite contains mostly domestic stocks, many of which operate in the technology sector.  The top 5 companies in the Nasdaq constitute nearly a 44% weighting. 

MSCI EAFE (Europe, Australasia, and Far East)

Developed and maintained by Morgan Stanley, the EAFE is an index that tracks the performance of stocks from 21 developed countries (excluding the U.S. and Canada).  Companies located in the U.K., Japan and developed Europe currently represents in excess of 85% of the MSCI EAFE index.

Barclays Aggregate Bond Index

The Barclays Aggregate Index is comprised of a basket of both corporate and government bonds of varying maturities and credit qualities.  The performance of this index is based on both interest payments and price appreciation (or depreciation) of the bonds held in the index.

For those investors who maintain a globally diversified investment approach, it is important to realize that the most commonly reported market indexes are not likely to be representative of your portfolio.