Stock indices explained

Stock indices are some of the most common places people put their money. But what exactly are indices, and why are they such common, trusted places to invest?

First, let’s establish something. You may not recognize the term “stock index,” but if you’re reading this blog, you’ve almost certainly heard of things like the Dow Jones Industrial Average or the S&P500. Those are indices. In short, indices are collections of stocks, based on some common characteristic. Here are some of the most common indices and what they have in common:

Index name	What lands you on the index
Dow Jones Industrial Average	Being one of 30 large, consistently-well-performing companies weighted by share price
S&P500	Being one of the 500 biggest publicly traded companies listed on US stock exchanges weighted by market capitalization
Nasdaq composite	Being traded on the NASDAQ stock exchange, which usually means the stock got there because it’s in tech weighted by capitalization
Russell 3000	Being one of the 3,000 largest publicly traded companies listed on US stock exchanges weighted by capitalization
Russell 2000	Occupying positions 1001 through 3000—the bottom 2000 entries—on the Russell 3000, when listed by capitalization

Before we understand why these investments are so well-liked, let’s look at what I’ve bolded. Some indices are "weighted by capitalization", and some are "weighted by price."

When you have a capitalization-weighted index, the bigger the total value of all the shares of your company, the bigger your company’s impact on the value of the index. But when you have a share-price-weighted index, the share price is what matters, not the total value of the company.

Let’s look at 2 examples: Apple and Microsoft, on the Dow and on the S&P.

• Apple’s market cap—the total value of all Apple stock—is just over $3 trillion. Microsoft’s is about $2.5 trillion.
• Apple’s share price, right now, is about $190, whereas Microsoft’s is about $340.

Since the Dow weights by price and Microsoft’s share price is higher, Microsoft’s performance has a bigger effect on the performance of the Dow than Apple’s performance. But since the S&P weights its components by capitalization, and Apple is worth about $500 billion more than Microsoft, Apple’s performance moves the S&P more than Microsoft’s.

A good day for Apple makes a more significant positive impact on the S&P, as just as good a day for Microsoft. A good day for Microsoft makes a bigger positive impact on the Dow, as just as good a day for Apple. 

(The same logic applies to bad days: bad days for Apple lower the S&P more than equally bad days for Microsoft, and bad days for Microsoft lower the Dow more than equally bad days for Apple.)

Professional financial advisors who act as fiduciaries (meaning they have to give you the advice that is in your best interest) recommend to so many people to invest in indices because they’re diverse. By putting your money into an index, you’re spreading that money out across dozens, if not hundreds or thousands, of companies. If one day, or even for a while, several of the companies listed as components of the index don’t do very well, the rest of the index might, so your losses won’t be as pronounced. The same is true of gains, though: if there’s one stock on the index that gains 10,000%  in a year, but everyone else gains about 12%, then by investing in that index, your returns will probably be much closer to 12% than 10,000%.