Market Indexes: What "The Market" Means

Why this matters

"The market fell 2% today" sounds like a single fact. It's actually a statement about one particular index, built in one particular way. Understanding indexes also prepares you for index funds, one of the most common ways people invest, which Part 2 covers.

What an index is

A market index is a number that tracks the combined performance of a defined group of securities. Instead of following thousands of stocks one by one, you can follow an index to get a sense of how a whole slice of the market is doing. An index is only a measurement, so you can't buy it directly. Index funds exist to copy one.

Three indexes you'll hear about

How weighting changes the answer

Two common designs decide how much each company counts:

• Market-cap weighted: bigger companies, measured by their total market value, count for more. This is how the S&P 500 and the Nasdaq Composite work.
• Price-weighted: companies with higher share prices count for more, no matter how big the company is. This is how the Dow works.

Imagine an index of three fictional companies:

Company	Share price	Shares	Market value
Alder	$300	10 million	$3 billion
Birch	$50	200 million	$10 billion
Cedar	$20	50 million	$1 billion

Now suppose one company's price rises 10% and nothing else changes:

If this rises 10%	Price-weighted index	Market-cap weighted index
Alder (small company, high price)	+8.1%	+2.1%
Birch (largest company, modest price)	+1.4%	+7.1%

In the price-weighted version, Alder dominates because its share price is highest, even though it's much smaller than Birch. In the market-cap weighted version, Birch dominates because it's the biggest business. Same companies, same price moves, very different index results.

Price return and total return

Many companies pay part of their profits to shareholders as dividends. An index can be measured two ways:

• Price return counts only the change in prices.
• Total return also counts dividends, as if they were reinvested.

The headline index numbers quoted in the news usually track price return. The Dow's standard version, for example, is a price-return index.² Over long periods, dividends can make a large difference, so comparing an investment's total return with an index's price return isn't a fair comparison.

Why "the market" can mean different things

Because the three indexes hold different companies and weight them differently, they don't always move together. On a day when large technology companies fall and other industries rise, the Nasdaq Composite can drop while the Dow gains. Neither is wrong. They're measuring different things.

Key takeaways

• A market index tracks the combined performance of a defined group of securities. You can't buy one directly.
• The S&P 500 and the Nasdaq Composite are weighted by market value. The Dow is weighted by share price.
• Weighting can change the answer dramatically, even with the same companies and price moves.
• Headline index numbers usually show price return, which leaves out dividends.

Check your understanding

In a price-weighted index, which company's price change has the biggest effect?

1. The one with the highest share price.
2. The one with the largest total market value.
3. Every company has an equal effect.

Your fund's total return last year was 11%. An index's headline return was 9.5%. Why might that comparison be misleading?

1. Funds and indexes can't be compared at all, because an index can't be bought.
2. The index return already includes fees, so it's lower than it should be.
3. The headline number may be a price return, which leaves out dividends.

What's next

You now know how markets work. The next module, How You Actually Invest, covers the practical side, starting with Brokerage Accounts: what they are and how to choose one.