A stock index is a list of stocks that are created to represent a certain segment of the market.
A stock index is not an investment, although there are investments that are designed to mimic stock indexes. More on that in a future post. For a definition of a stock, see my prior post where I answered the question “What is a stock?”
Stock index – segmenting the market
Let’s take the United States stock market as an example, it can be segmented many different ways; Large Company stocks, Mid-Sized Company stocks, Small Company stocks, Large Company Value stocks, Small Company Growth stocks, the list could go on and on. There is even a St. Louis Stock Index called the Bloomberg St. Louis Index. One or more indexes (or lists of stocks) can be created for each of these segments.
What the purpose of a stock index
The purpose of a stock index is to give you a quick measurement of the performance of that segment of the market that day and over time.
Large Company Stock index
Even within one segment of the market, there can be more than one index created to represent that segment of the market. Take the United States Large Company stock market for example, three common indexes that represent the US Large Company stock market are:
- Dow Jones Industrial Average: “The Dow”, 30 companies on the list, does not represent all industries
- S&P is 500: 500 of the largest companies in the US; covers 75% of the US equities
- Russell 1000: approximately 1000 of the largest companies in the US; covers 92% of the US equities
Dow Jones, S&P and Russell are all companies that compile the list of stocks that comprise each respective index.
With lists that range from 30 stocks to 1000 stocks to represent the Large Company stock market it is easy to see why the indexes do not move in lock step.
The Dow or S&P 500
According to The Dow Jones Indexes website, the Dow was one of the first market indicators, which is probably why it is quoted every day, it is tradition. However, 30 stocks is not a very good representation of the overall Large Company stock market, especially considering it is not representing all industries. That is why you also hear the S&P 500 index quoted as well. There are some days in which one of these indexes ends the day down, and the other ends the day up, even though they both represent the Large Company stock market. They can not measure the segment in exactly the same way since they are looking at two different lists of stocks.