In recent years, investing in stock market indexes has become increasingly popular. They allow the investor to participate in the broad stock market – or a slice of it – but without needing to choose which stocks to invest in. This largely explains the explosive growth in exchange-traded funds (ETFs), which are commonly based on market indexes.
Three of the most popular stock indexes are based on the S&P 500, the Dow Jones Industrial Average, and the NASDAQ. Each provides the investor with the ability to invest in the largest companies in the United States.
But what’s the difference between the three major indexes, and which one should you choose for your own investing activities?
What are stock market indexes?
A stock market index tracks the performance of a group of stocks and attempts to determine the performance of the group, based on price movements of the individual components within the index. It effectively reduces the performance of a large number of stocks to a single number. The number can easily be tracked to determine how the underlying market or market segment is performing.
In 2017, Bloomberg reported that there are now more stock market indexes than there are stocks trading on US stock exchanges. There are about 5,000 indexes, compared to just over 3,500 publicly traded stocks.
How is it possible to have so many indexes that they outnumber the stocks they represent?
It’s not an exaggeration to say that there are indexes to represent just about every possible configuration of stocks, bonds, and other securities imaginable. Because there are so many possible combinations, and because investors increasingly want greater investing precision, the number of indexes can continue to grow.
But the three most popular indexes are based on the S&P 500, the Dow Jones Industrial Average, and the NASDAQ.
The S&P 500 Index (Ticker: SPX)
The S&P 500 Index tracks the performance of the (roughly) 500 largest publicly traded companies on US stock exchanges. The primary determining factor for inclusion in the index is the market valuation of a company’s stock. The index generally attempts to incorporate those companies with the largest market capitalizations.
Based on market capitalization alone, the index represents about 80% of the total value of all publicly traded companies in the US. This is irrespective of whatever exchange those stocks trade on.
The S&P 500 Index has become the most popular index, with dozens of index funds tied to it. It’s virtually a staple allocation with robo-advisors.
Dow Jones Industrial Average (DJIA) Index (Ticker: DJI)
The Dow Jones Industrial Average Index is the most narrowly focused of the major indexes. However, given that it represents stocks of the largest companies in the US, it remains a popular index.
Interestingly, with just 30 stocks, the DJIA Index represents approximately 25% of the total market capitalization of all US stocks. This demonstrates the degree of concentration of capital invested in the largest companies.
In recent years, the DJIA Index has underperformed the S&P 500 and the NASDAQ Composite indexes, and by a surprisingly large margin. This owes to the fact that the 30 component stocks represent well-established companies that dominate their respective industries, and have far less growth potential than many of the companies included in the other indexes.
Component companies include some of the best-known names in American industry, including:
- American Express.
- The Home Depot.
- Johnson & Johnson.
- Procter & Gamble
NASDAQ Composite Index (Ticker: IXIC)
Representing the performance of more than 2,900 stocks, the NASDAQ composite index is the broadest of the three major indexes. In fact, the index encompasses most of the stocks listed on the NASDAQ exchange.
The largest share of stocks in the exchange and in the index are in the technology sector. This largely explains why the index has outperformed both the DJIA and the S&P 500 indexes over the past decade.
And while the DJIA and S&P 500 indexes focus on the largest companies in America, the NASDAQ Composite incorporates large-, medium-, and small-capitalization companies. It may be the single best index to gain the broadest exposure to the entire collective US stock market.
How do stock indexes work?
A stock market index is tied to the performance of an exchange, industry sector, specific market, country, or even specific stocks within any of those categories.
The index tracks the collective performance of the stocks or other securities included within the index. In that way, the index will match the performance of the underlying securities – neither exceeding it, nor underperforming it.
ETFs and many mutual funds are increasingly index-based. An index fund maintains its portfolio consistent with the index, attempting to match it as closely as possible. This will include the individual stocks in the index, as well as the pro-rata market capitalization of each.
However, not all indexes operate in the same manner.
For example, both the S&P 500 Index and the NASDAQ Composite Index are what’s known as market-weighted. That means each stock included in the index has a proportion based on market capitalization. It also means the companies with the highest market capitalization have a disproportionate influence on the performance of the overall index.
The Dow Jones Industrial Average is a price-weighted index. It uses an average of the share price of each company in the index, which is then divided by the number of companies included in the index. The index level is complicated by the numerous stock splits and other activity that has affected the stock of participating companies.
How to invest in stock indexes
Fortunately, investing in stock indexes is as easy as investing in stocks themselves. The main question is whether you want to invest in stock indexes directly, or indirectly through an investment manager.
Managed investment options
If you want to invest in stock indexes, but don’t want to select which ones or manage them going forward, you can choose to invest with a robo-advisor.
As an example, Betterment will invest your account in index funds that cover the US total stock market, US value stocks for large-, medium-, and small-cap stocks, international developed and emerging markets stocks, and several bond index funds. They’ll give you complete market diversification through a portfolio of a handful of index-based funds.
If you prefer to choose your own index funds, you can do that through a brokerage account. A good option is TD Ameritrade, since it provides an opportunity to participate in other investments, like actively managed mutual funds, bonds, and real estate investment trusts, in addition to index based ETFs.
If you’re looking for a simple trading app, consider Robinhood or Public. Each is a commission-free trading app, allowing you to invest in stocks, as well as index-based ETFs. These are more limited trading platforms, but if you’re looking primarily to invest in index funds, both will get the job done seamlessly.
The best of both worlds?
There’s one more option you may want to consider, which is something of a hybrid between investment brokers and robo-advisors. That’s M1. It’s unique in that it’s a robo-advisor providing complete portfolio management, but it also allows you to select your own investments.
M1 uses a methodology called “pies”. Each pie is a portfolio comprised of up to 100 ETFs and/or individual stocks. You can either select from pre-built pies, or build your own from the ground up. That means your pie can include any index-based funds you want. Once a pie is created, M1 will fully manage it – free of charge!
Stock indexes other than the “Big Three”
While the S&P 500, DJIA, and NASDAQ Composite indexes represent the largest in the field, they’re far from the only ones.
Examples of other types of indexes include the following:
- The Wilshire 5000. This index encompasses the entire US stock market. The specific number “5,000” refers to the approximate number of publicly traded companies at the time the index was launched in 1974. However, the number of publicly traded stocks has declined significantly since then.
- Industry sector indexes. Indexes have been developed within the broader markets. For example, within the S&P 500 index, there are sub-indexes for consumer staples, energy, financials, healthcare, and technology stocks, among others.
- Market capitalization indexes. These indexes are based on the size of publicly traded companies, based on market capitalization. There can be indexes based on large-cap, medium-cap, small-cap, and even micro-cap stocks.
- Foreign stock indexes. There are indexes for the UK FTSE, Japan’s NIKKEI, and other stock markets in China, Europe, and elsewhere. By investing in the index of stocks traded in a specific country, you’ll be getting broad exposure to that market.
The above are just general index categories. Since there are thousands of indexes, it’s impossible to list each category they represent.
What are the differences between the various indexes?
The table below summarizes each of the three biggest stock market indexes, how they work, what makes them unique, and their respective investment performance over the past 10 years.
Category S&P 500 Dow Jones NASDAQ
What the index represents The 500 largest publicly traded companies in the United States The 30 largest publicly traded companies in the United States Domestic and foreign stocks listed on the NASDAQ
Specialization Large-cap US stocks The biggest companies in the US The broad stock market, with a heavy emphasis on technology
How do you choose an index? And which one is best for you
In a real way, index investing has become much like investing in stocks. That’s because there are now thousands of index funds to choose from.
To get the job done, you’ll need to determine what your own investment preferences are. Do you want to invest in the general market? Or are there specific market segments you think are likely to outperform the general market?
If you’re content to match the general market, you can invest in a broad index fund, like the S&P 500 or the NASDAQ Composite.
But if you believe certain sectors, like small-cap stocks, healthcare, or technology are likely to outperform the general market, you’ll want to select funds that invest in indexes tied to those sectors.
No matter which indexes you choose to invest in, it’s important to maintain a balanced portfolio. That means you’ll need to hold some cash and bonds next to your stock index funds. And, conveniently, there are even bond index funds you can choose for that purpose.
For example, you can invest in index funds that specialize in intermediate-term bonds, high-grade US corporate bonds, U.S. Treasury securities, or high-yield bonds.
The bond funds will offer some protection to your portfolio if stocks take a tumble.
What should you look for in an index?
Once you’ve selected the type of index you want to invest in, you’ll need to drill down into the details.
One of the most important is the fees charged by the fund. Commonly referred to as expense ratios, these can range from under 0.10% to something approaching 1%. You’ll want to stay as close to a lower end as possible.
For example, the Vanguard 500 Index Fund Investor Shares (VFINX) has an annual expense ratio of just 0.14%. It’s tied to the performance of the S&P 500 index, but the low expense ratio will give it a better long-term performance than a fund with an expense ratio of say, 0.25%.
You should also look at the actual performance of the index fund, compared with its benchmark index. Most index funds slightly underperform the underlying index, which reflects the expense ratios of the fund. You’ll want to invest in the index fund that most closely approximates the performance of the underlying index.
Both expense ratios and investment performance information are available on a fund’s website or in its prospectus.
How to use each index
You should take advantage of the specialization index funds offer. For example, while you may hold most of your investments in an S&P 500 index fund, you may decide to move some money to an international index fund if you believe the markets in certain countries will outperform US markets.
If you believe the Japanese economy and stock market are likely to perform better than the US over the next few years, you may want to move some money into an index fund based on Japan’s NIKKEI 225 Index (NIK).
But you also have an opportunity to invest in index funds tied to the performance of multiple foreign stock exchanges.
The same is true with individual market sectors. If you believe technology will continue to outperform the general stock market, you can invest in index funds specializing in technology companies.
The benefits of investing in an index
Index investing has become very popular in recent years, and there are plenty of reasons why that’s true.
Very few investors outperform the general market
Statistically speaking, very few investors – or fund managers – outperform the general market, especially over the long-term. By investing in an index-based fund, you’ll match the performance of the underlying market. That means you won’t miss out as the general market rises.
Index investing is a low-cost way to invest
Since index investing is tied to the underlying index, there’s very little trading within index funds. That reduces the operating cost of the fund because it minimizes transaction fees.
The lower fees of index investing translate into higher net returns. For example, if the market rises by 7%, and the fees within the fund are no more than 0.10%, your net return will be 6.9% – almost as much as the general market rise itself.
But if you invest in an actively managed fund that trades frequently in an attempt to outperform the market, the fees within the fund may be more like 0.50%. That being the case, the general market return of 7% will be reduced to 6.5%.
That seemingly small difference will make a big impact on the long-term performance of your investment.
You don’t need to choose securities or manage your stock portfolio
Index investing is passive investing at its best. You invest a certain amount of money in an index fund, which eliminates the need to choose individual stocks to invest in.
Meanwhile, all the details of managing the fund are handled for you automatically. All you need to do is invest money in a fund, and all the work will be done for you.
You’ll never underperform the market
There’s probably nothing scarier to an investor than getting a 5% return in a market that generates 10% gains, or getting a 10% loss in a market that’s lost only 5%.
Since index investing is tied to the performance of the underlying index, your investment results will never be worse than that of the market itself.
You can select an index if you believe it is about to outperform other indexes
Since there are so many different indexes, you can choose which ones will work best for you. For example, while you may have most of your stock portfolio invested in an S&P 500 index fund, you may want to allocate smaller amounts to specific sectors.
If you believe technology and healthcare will outperform the general stock market, you can invest in index funds tied to those sectors. Once again, you won’t need to worry about stock selection or managing your investments.
The drawbacks of investing in an index
Despite the explosion in the number of indexes and the funds that track them, and the tremendous amount of investment capital pouring into them, investing in indexes isn’t without a few problems.
Diversification may not be as wide as expected
The primary reason for investing in an index is achieving a greater level of diversification. That’s easier to do when you invest in a fund tied to an index that represents hundreds or thousands of individual stocks.
But diversification is not always achieved. For example, though the NASDAQ Composite includes nearly 3,000 stocks, about 40% of the market capitalization of the index itself is represented by just six companies.
Those companies include Apple, Microsoft, Amazon, Tesla, Facebook, and Google. The remaining 2,913 stocks comprising the index represent the other 60%.
Investment returns are tied to the performance of the index
Many investors hope to outperform the general market. This explains the popularity of actively managed mutual funds, which attempt to outperform the general market.
But if you are invested in a fund tied to an index, the fund will never do better – or worse – than the performance of the index itself.
Index funds don’t protect from market losses
Stock prices can go down, sometimes seriously. The fact that you are invested in an index fund doesn’t eliminate this threat.
For example, during the stock market meltdown of 2007 – 2008, the S&P 500 lost about 50% of its value. In the Dot-com bust of 2000 – 2002, the NASDAQ Composite lost more than 80% of its value.
As we know today, both indexes have since recovered and gone on to reach new highs. But not only was the ride down in both crashes a scary one, but each also required holding onto your investment for many years before returning to the previous peak level.
Investing in index funds may prevent your portfolio from doing worse than other investors. But they provide no guarantee that you’ll never lose money.
You can invest in index funds and never really learn how to invest
For most investors, this isn’t a problem. They simply want to participate in general market gains, without getting involved in the mechanics of portfolio creation, security selection, portfolio rebalancing, dividends reinvesting, or knowing when to buy and sell what stocks.
But precisely because it avoids all those steps in the investing process, index funds keep the investor from spreading their investment wings, perhaps to pursue higher investment returns.
In a real way, investing in index funds is less about investing in stocks, and more about investing in indexes. The quality and future prospects of the companies within a given index become completely irrelevant to the investor.
For most investors, index investing should represent the largest allocation of your stock portfolio. You can build a foundation of index funds, then gradually add actively managed mutual funds or even individual stocks as you grow more comfortable with the investment process.