The Importance of Stock Market Indexes

DETERMINING WHICH INDEX TO USE

Studies have shown that all the indexes are correlated; that is, they all move together in the same direction. However, there are some differences. The Nasdaq and the AMEX indexes are not as highly correlated with the S&P 500 and the DJIA. This makes sense because companies in the Nasdaq and AMEX indexes are younger, smaller, and riskier than the companies in the DJIA and S&P 500 Index. The best approach is to choose the index that closely resembles the makeup of your stock portfolio.

Individual measures of the market are convenient indicators or gauges of the stock market. These market indexes are convenient gauges of the stock market that also indicate the direction of the market over a period of time. By using these market indexes, you can compare how well individual stocks and mutual funds have performed against comparable market indicators for the same period.

THE IMPORTANCE OF STOCK MARKET INDEXES

Although the stock market is much more dynamic than the indexes suggest, along with the fact that there are different ways to calculate the indexes, causing calculation bias, the stock market indexes are useful in a number of ways to stock investors. First, the market indexes provide an historical perspective of stock market performance, giving investors more insight into their investment decisions. Investors who do not know which individual stocks to invest in can use indexing as a method of choosing their stock investments. By wanting to match the performance of the market, investors can invest in index mutual funds or index exchange-traded funds (ETFs) that track the performance of the indexes with which they are aligned. This form of investing gives investors the opportunity to do as well as the markets and not significantly underperform the markets.

The second benefit of stock market indexes is that they provide a yardstick with which investors can compare the performance of their individual stock portfolios. Individual investors with professionally managed portfolios can use the indexes to determine how well their managers are doing in managing their money.

The third major use of stock market indexes is as a forecasting tool. Studying the historical performance of the stock market indexes, you can forecast trends in the market. The Internet bubble is a prime example, which in hindsight provides 20/20 vision. The price-to-earnings (P/E) ratio of the stock markets was in the high 20s to low 30s in 1999–2000, indicating that the markets could not sustain the rapid increase in stock prices. The P/E ratio for the market historically has ranged between the high single digits and the low 30s, with an average around 15. The P/E ratio for the S&P 500 was 17 on August 4, 2006, an indication that the stock market was not particularly overvalued. Consequently, the market indexes provide investors with a useful tool for forecasting trends in the market.

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