While driving in your car and listening to the radio, it’s common to hear something like: “The Dow was up 500 points today, while the S&P was up 2%.” The commentators are talking about the daily performance of stock market indexes. These indexes represent a hypothetical portfolio of investment holdings, capturing a specific segment of the financial markets.
A stock index value is calculated based on the prices of its underlying components. “Components” means individual company stocks. Various indexing methodologies exist, including price-weighting, and most commonly, market-cap weighting. This is how the S&P 500 is constructed. Weighting adjusts the impact of individual items within an index. So, a larger company like Apple will have a greater weighting in the S&P 500 than a smaller company.
Think of an index as a measuring tool for a section of the stock market. It tracks changes in share prices across different companies. Financial institutions and investors widely use indexes to compare investment returns and describe overall market trends.
Indexes aggregate data from diverse companies across industries depending on the index. This collective data provides a snapshot that allows investors to compare current price levels with historical prices. This aids in assessing market performance. Some indexes focus on specific subsets, such as the Nasdaq stock index, which closely tracks the technology sector. Others, like the S&P 500, track the 500 largest companies in the US. Furthermore, an index like the MSCI ACWI tracks companies across developed and emerging markets worldwide.
Indexes come in various sizes and serve distinct purposes. Some track only a handful of stocks, while others analyze thousands. Different investors have varying interests, leading to indexes that separate large, mid-sized, and small companies. Additionally, indexes may employ strategies like growth, value, or dividend investing to select component stocks.
Prominent Indexes
Some of the most popular stock indexes for monitoring markets are:
- Dow Jones Industrial Average (DJIA): A stock market index of 30 large U.S. companies. It’s one of the oldest and most followed indexes. However, many consider it to be a less-than-ideal gauge of the overall U.S. stock market compared to a broader index such as the S&P 500. The DJIA includes only 30 large companies. It’s price-weighted, unlike the S&P 500, which uses market capitalization for its weights.
- S&P 500 Index: An index of the 500 largest US companies by market capitalization weighting.
- Nasdaq Composite Index: This is a market capitalization-weighted index of more than 2,500 stocks. It’s a wide-ranging index that is significantly weighted toward the U.S. technology sector.
- Russell 2000 Index: Consisting of 2,000 small-cap companies, this is generally regarded as the best benchmark of how smaller U.S. companies are performing. Small-cap stocks tend to be more volatile than large caps. However, they also tend to outperform large-cap stocks over the long run.
- Russell 3000 Index: This is considered a true “total stock market” index. It captures the entire U.S. investable market. The premise behind the Russell 3000, and funds that track it, is that it gives exposure to the entire U.S. stock market.
- MSCI All Country World Index (ACWI): This is a stock index designed to track broad worldwide equity market performance. It includes the stocks of nearly 3,000 companies from 23 developed countries and 24 emerging markets as of Dec. 29, 2023. It’s the broadest, most geographically diversified market index on this list covering a wide array of industries.
There are dozens more indexes that we won’t list here. Many are targeted to specific parts of the world & toward various strategies like growth or value or dividend. There’s also bond indexes and real estate indexes, but for brevity’s sake, we won’t list them. The concept is the same however, in that each index is a collection of individual securities of that asset class.
The Importance and Uses of Stock Market Indexes
Now that we understand what stock market indexes are and the various types, let’s dive into their uses and highlight why they’re important.
Index Funds: A Low-Cost Investment Option
Institutional fund managers utilize indexes as a foundation for creating index funds. For individual investors, directly buying all index holdings is often prohibitively expensive and time-consuming. Index funds are a cost-effective way to gain exposure to specific market segments. These funds try to replicate index performance, with management and trading costs significantly lower than those of actively managed funds.
Indexes Give Investors a Snapshot of a Market Sector
Indexes provide investors with a simplified view of a large market sector, without having to analyze every single asset in that index. For example, it wouldn’t be feasible for an ordinary investor to study thousands of different stocks in order to understand the changing prospects of different technology companies. However, a sector-wide index like the NASDAQ-100 Technology Sector Index can display how this sector has performed.
Indexes as Benchmarks
Indexes serve as benchmarks for different purposes in the financial markets. If your money is being managed by an investment company, you may want to compare their performance to a particular benchmark index, say the MSCI All Country World Index (ACWI) and see how they stack up.
Which Index Should You Focus On?
The question of which index you should focus on comes down to what your objective is and what type of stocks you’d like to track. A technology-focused investor may focus on the Nasdaq-100 while a small cap investor would track the Russel 2000. For investors that are globally diversified however, probably the best index to focus on is the MSCI All Country World Index (ACWI).
This index gives investors exposure to the broadest array of global stocks in developed and emerging markets. The ACWI covers a total of almost 50 nations and 3,000 different equities, allowing for extremely high diversification. It encompasses a broad range of companies and industries, including technology, healthcare, finance, consumer goods, among others.
The index is managed by MSCI (Morgan Stanley Capital International), a supplier of tools and services for investment decision management. The index is reviewed quarterly and rebalanced semi-annually to make sure that it displays changes in the global equity markets.
Investment firms use the MSCI ACWI as a benchmark to measure the performance of their portfolios and a guide to world-wide diversification. Individual investors also use the ACWI as a benchmark to compare which funds have the best risk-adjusted returns.
By tracking the ACWI index, investors can diversify their risk across multiple regions and sectors. This minimizes the effect of any one country or industry on their portfolio. In finance terms, this reduces “non-systematic” or “company specific” risk. This is the risk we look to minimize as investors, leaving us only exposed to “systematic” or “market-wide” risk, which can’t be avoided.
Investing in the MSCI ACWI does have a few drawbacks. It’s primarily weighted towards developed markets, which represents about 75% of the index. So, many smaller countries that are not major contributors to global growth are not included in the index. Secondly, the index is heavily skewed toward large-cap stocks, which can limit potential returns, compared to having more small-cap exposure. Finally, the index doesn’t consider ESG factors, which may be preferred by some investors. However, these detractions are dwarfed by the benefits that the index does provide. It’s simply the most comprehensive gauge of the global equity market, providing extreme diversification benefits.
Determining whether it’s a suitable investment for you depends on your specific investment goals, risk tolerance, and individual circumstances.
The ACWI is intended as a long-term investment, particularly well-suited for investors with a wide-ranging investment horizon. Although the MSCI ACWI may experience short-term volatility, it has historically delivered consistent returns for long-term holders.
