
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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