Investing in the stock market is not for the faint-hearted. There are big returns to be made, but there are also substantial risks, and unwary private investors can easily be caught out. So if an investor has decided to manage his own portfolio, then a period of caution is a good idea. The wise investor will not jump in, but will take time to understand the market. A key to that preparation is to watch the indices.
There are two commonly used systems of weighting the daily movement of stock prices to give an average. Imagine an index that has two stocks, A with 10,000 shares at $1 dollar each, and B with 100 shares at $10 dollars each. So A is ‘worth’ $10,000, and B is worth $1,000. After a day’s trading A’s shares are at 80 cents (down by 20%), and B’s are at $12 (up by 20%), making A worth $8,000 and B $1,200.
A ‘price-weighted’ index looks at the value of individual shares. At the end of the day the average share price has gone up from $5.50 to $6.40, an increase of about 16%.
A ‘market capitalization-weighted’ index looks at the overall value of the companies. The average value has gone down from $5,500 to £4,600, a decrease of about 16%.
An unweighted index would show the effect on $100 dollars invested in each, which would break even.
Of course it is much more complicated in real life, but the point is that a price-weighted index will give more prominence to the movement of expensive shares, whereas a market-weighted index will emphasize the movement of bigger companies.
Dow Jones is the world’s leading index provider. The index that is most often quoted in news items is the Dow Jones Industrial Average.
The DJIA tracks the 30 largest companies in the U.S. This represents about 25% of the market, and it is often taken as a good indicator of the direction of the economy as a whole. However it has its limitations for an investor. This is partly because it is price-weighted, and partly because it does not include smaller companies which often move differently from the biggest thirty.
The Lower End
At the other end of the scale is the Russell 2000 index, the bottom two-thirds of the Russell 3000 which represents the 3,000 largest companies. Because these companies represent a very wide range of sectors, it is a fairly good indicator of what is going on in the world of small to medium businesses, which can often follow a different path from the big boys.
The Whole Picture
The Wiltshire 5000, despite its name, tracks more than 6,700 companies, effectively the whole of the publically-traded sector in the U.S. It is therefore a very good indicator of the way things are moving across the country, but it does not indicate which sectors are doing well and which are not so healthy.
This index, like most apart from the DJIA, is market capitalization-weighted.
A Middle Path
The Standard & Poor’s 500 Stock Index analyzes the top 500 companies in the U.S. accounting for about 80% of the value of American companies. The index is capitalization-weighted, and many commentators regard it is a good indicator of the state of the market generally. It represents all major sectors of the economy as far as larger companies are concerned.
As well as the general indices, there are others which indicate the movement in particular areas of commerce and industry. The best known is probably the NASDAQ Composite Index, which follows the trading of technology related stocks on the NASDAQ stock exchange. It includes both large and small companies, not all of which have headquarters in the U.S. As well as the established technology firms, the NASDAQ also includes more speculative companies, so the index shows the confidence of the market in both areas.
If investors want to look at individual companies, they can us online resources to seek informed opinion on prospective share values. For instance investors who want to check up on the prospects of Facebook could look up an article in the Money Morning info pages for an in-depth assessment of what can be expected.
Do the Math
Investing in the stock market is exciting and potentially very profitable, but it is important to approach it carefully and remain ever alert to the way the markets are moving. The indices are an invaluable tool and one which any go-it-alone investor needs to study.
Danielle Richardson learnt about the stock market as a child thanks to her Father, but it wasn’t until her 30s that she really started to take an interest herself, it soon developing into a passion — It’s in her blood! She writes about the stock market for experienced traders as well as newbies just starting out.