What’s the big deal about stock indexes?

The Conversation (TC): What are stock indexes?Alexander Kurov (AK): Stock indexes measure the performance of a group of stocks.



When prices rise or fall overall for the shares of those companies, so do stock indexes. The number of stocks in those baskets varies, as does the system for how this mix of shares gets updated.



The Dow Jones Industrial Average, also known as the Dow, includes shares in the 30 US companies with the largest market capitalisation – meaning the total value of all the stock belonging to shareholders. That list currently spans companies from Apple to Walt Disney Co.



The S&P 500 tracks shares in 500 of the largest US publicly traded companies.



The Nasdaq composite tracks the performance of more than 2 500 stocks listed on the Nasdaq Stock Exchange.



The Dow, launched on 26 May 1896, is the oldest of these three popular indexes, and it was one of the first to be established.



Two enterprising journalists, Charles Dow and Edward Jones, had created a different index tied to the railroad industry a dozen years earlier.



Most of the 12 stocks the Dow originally included wouldn’t ring many bells today, such as Chicago Gas and National Lead. But one company that only got booted in 2018 had stayed on the list for 120 years: General Electric.



The S&P 500 index was introduced in 1957 because many investors wanted an option that was more representative of the overall US stock market. The Nasdaq composite was launched in 1971.



You can buy shares in an index fund that mirrors a particular index. This approach can diversify your investments and make them less prone to big losses.



Index funds, which have only existed since Vanguard Group founder John Bogle launched the first one in 1976, now hold trillions of US dollars.



TC: Why are there so many?



AK: There are hundreds of stock indexes in the world, but only about 50 major ones.



Most of them, including the Nasdaq ­composite and the S&P 500, are value-weighted. That means stocks with larger market values account for a larger share of the index’s performance.



In addition to these broad-based indexes, there are many less prominent ones. Many of those emphasise a niche by tracking stocks of companies in specific industries like energy or finance.



TC: Do these milestones matter?



AK: Stock prices move constantly in response to corporate, economic and political news, as well as changes in investor psychology.



Because company profits will typically grow gradually over time, the market usually fluctuates in the short term, while increasing in value over the long term.



The Dow first reached 1 000 in November 1972, and it crossed the 10 000 mark on 29 March 1999. On 2 January 2024, it surpassed 38 000 for the first time. Investors and the media will treat the new record set when it gets to another round number – 40 000 – as a milestone.



The S&P 500 index had never hit 5 000 before, but it had already been breaking records for several weeks.



Because there’s a lot of randomness in financial markets, the significance of round-number milestones is mostly psychological. There is no evidence they portend any further gains.



For example, the Nasdaq composite first hit 5 000 on 10 March 2000, at the end of the dot-com bubble.



The index then plunged by almost 80% by October 2002. It took 15 years – until 3 March 2015 – for it to return to 5 000.



By mid-February 2024, the Nasdaq composite was nearing its prior record high of 16 057 set on 19 November 2021.



Index milestones matter to the extent that they pique investors’ attention and boost market sentiment.



Investors afflicted with a fear of missing out may then invest more in stocks, pushing stock prices to new highs. Chasing after stock trends may destabilise markets by moving prices away from their underlying values.



When a stock index passes a new milestone, investors become more aware of their growing portfolios. Feeling richer can lead them to spend more.



This is called the wealth effect. Many economists believe that the consumption boost that arises in response to a buoyant stock market can make the economy stronger.



TC: Is there a best stock index to follow?



AK: Not really. They all measure somewhat different things and have their own quirks.



For example, the S&P 500 tracks many different industries. However, because it is value-weighted, it’s heavily influenced by only seven stocks with very large market values.



Known as the “Magnificent Seven”, shares in Amazon, Apple, Alphabet, Meta, Microsoft, Nvidia and Tesla now account for over one-fourth of the S&P 500’s value. Nearly all are in the tech sector, and they played a big role in pushing the S&P across the 5 000 mark.



This makes the index more concentrated on a single sector than it appears.



But if you check out several stock indexes rather than just one, you’ll get a good sense of how the market is doing. If they’re all rising quickly or breaking records, that’s a clear sign that the market as a whole is gaining.



Sometimes the smartest thing is to not pay too much attention to any of them.



For example, after hitting record highs on 19 February 2020, the S&P 500 plunged by 34% in just 23 trading days due to concerns about what Covid-19 would do to the economy. But the market rebounded, with stock indexes hitting new milestones and notching new highs by the end of that year.



Panicking in response to short-term market swings would have made investors more likely to sell off their investments in too big a hurry – a move they might have later regretted. This is why I believe advice from the immensely successful investor and fan of stock index funds Warren Buffett is worth heeding.



Buffett, whose stock-selecting prowess has made him one of the world’s 10 richest people, likes to say “Don’t watch the market closely”.



If you’re reading this because stock prices are falling and you’re wondering if you should be worried about that, consider something else Buffett has said: “The light can at any time go from green to red without pausing at yellow”.



And the opposite is true as well.







 – The Conversation