Which index is right for you: Dow Jones vs. Nasdaq vs. S&P 500

When determining the state of the US economy, most investors turn to one of three market indexes: the Dow Jones Industrial Index (DJIA), the Nasdaq Composite, and the S&P 500. However, despite their popularity, a lot of investors don’t have a great idea of what these indexes are or what they mean.

Let’s talk about stock market indexes, the differences between the top three, and how to use them in making investment decisions.

What’s a Stock Market Index?

A stock market index tracks a portfolio of investments made to represent the performance of a particular market or sector. It serves as a benchmark for investors to compare to other stocks, portfolios, or historical periods.

For example, the S&P 500 index aims to indicate the performance of the US economy. Therefore, a negative event like a pandemic or natural disaster often leads to a decline in its price. In contrast, a new government policy indicating economic confidence may cause a rise.

So, what else do market indexes track?

On the other hand, some market indexes represent a smaller subset of the market. Typically, they’ll divide the market into categories based on company attributes. For example, the Russell 2000 reflects the performance of 2,000 small-cap companies. In other words, its holdings are relatively low-value compared to those in other indexes, with an average market capitalization of $1.23 billion in August 2021.

Other indexes track companies in a particular sector. For example, the MSCI US Investable Market Index/Consumer Staples 25/50 tracks the performance of consumer staples companies across all market capitalization levels. Sector-specific market indexes can help investors easily determine the industries in which growth and innovation are taking place.

Dow Jones Industrial Index

The Dow Jones Industrial Index (DJIA), also known as the Dow, is an index made up of 30 large, blue-chip companies in the US. The index originated in 1896, second only after the Dow Jones Transportation Average.

Structure of the Dow Jones Industrial Index

Although the Dow originally consisted mainly of industrial companies, it later expanded to include other sectors. Nowadays, the index contains businesses from all industries, from Goldman Sachs to McDonald’s.

Whereas many other market indexes are capitalization-weighted, the Dow is price-weighted. In other words, each company makes up a fraction of the index based on its stock price.

A typical price-weighted index would be constructed by adding together one share of each stock, then dividing by the number of companies to get the index price. However, due to complicating events over the years, such as stock splits and spin-offs, the Dow’s pricing has gotten more complicated.

Qualifications for the Dow Jones Industrial Index

With limited holdings of only 30 companies, inclusion in the Dow is quite exclusive. In order to even be considered in the first place, companies must meet certain criteria:

• To start, they must be included in the S&P 500.
• Additionally, the Dow’s investments must also fall outside the transportation and utility sectors. Otherwise, they’d be included in the Dow Jones Utility Average (DJUA) or the Dow Jones Transportation Average (DJTA).
• Most importantly, companies in the Dow are typically well-established household names.

Nasdaq Composite Index

The Nasdaq Composite Index is a basket made up of nearly 3,000 companies sold on the Nasdaq Stock Market. It launched in 1971, at the same time as the stock exchange it represents.

Unlike the Dow, the Nasdaq includes companies both inside and outside the US. It’s also known for being heavily skewed toward the tech sector.

Structure of the Nasdaq Composite Index

Unlike the Dow, the Nasdaq is a capitalization-weighted index. That means that larger, more valuable companies have a larger effect on the index’s performance.

Weighting portfolio holdings by market capitalization is pretty standard for indexes. However, some argue that giving larger companies more influence can create a distorted depiction of the market. Either way, it’s important to understand how the system works so you know how to interpret the index’s movements.

Qualifications for the Nasdaq Composite Index

The Nasdaq Composite requires its holdings to be listed exclusively on the Nasdaq Stock Market. However, it’ll make exceptions for equities that have been dually listed from before January 1, 2004.

S&P 500 Index

The S&P 500 measures the performance of 500 of the largest publicly-traded US-based companies, encapsulating roughly 80% of the value of the US stock market. It was originally founded in 1923, representing 233 companies across 26 industries.

However, the index as we now know it was launched officially in 1957. Since then, it’s become a joint venture among S&P Global, CME Group, and News Corp.

Structure of the S&P 500 Index

As previously mentioned, the S&P 500 includes 500 US companies. However, its number of stocks can stretch above 500, thanks to multiple classes of shares from some companies.

Similar to the Nasdaq Composite, the S&P 500 is a capitalization-weighted index. For this reason, it can face some of the same criticisms about creating a distorted image of the economy.

Qualifications for the S&P 500 Index

In order to be included in the S&P 500, companies must meet a long list of qualifications:

• First of all, they must meet a market capitalization threshold, which was raised to $13.1 billion in June 2021.
• Additionally, 50% of company stock should be available to the public, and it should meet a minimum share price of $1.
• The business must also meet certain regulatory requirements. For example, they must have 50% of fixed assets and revenue in the US.
• They need to file a 10-K annual report.
• Companies must be listed on a reputable stock exchange, such as the NYSE, Investors Exchange, Nasdaq, or BATS Global Markets.

Which Market Index Is Right For You?

While the Dow, the Nasdaq, and the S&P 500 all represent the US market, there are significant differences among the three. When choosing an index to follow, it’s important to weigh its pros and cons.

For example, some investors may be put off by the price-weighted structure of the Dow. However, others may be drawn to the stability of its blue-chip holdings.

Similarly, the S&P 500 and the Nasdaq may appear more attractive due to their diversified investments. Unfortunately, they’re also skewed more heavily toward high-value companies, particularly those in the tech sector. Therefore, some find that they’re not as representative of the US economy as a whole.

👍 Fortunately, when it comes to stock market indexes, you don’t have to choose. Rather than investing solely in a single index, you can diversify your portfolio further by dedicating a fraction of your money to each one.

How to Invest in a Stock Market Index

When it comes to investing in a stock market index, you have two main options.

1. On the one hand, you can buy a share in each of the index’s holdings.

However, this may require more effort and money than many investors can afford, especially with some stock prices reaching well into the thousands.

2. A more common option is purchasing an index fund.

Often structured in the form of a mutual fund or exchange-traded fund (ETF), an index fund represents a basket of underlying investments. For example, the SPDR S&P 500 ETF Trust (SPY) allows investors to share in the performance of the S&P 500 without needing to buy all of its investments. Similarly, investors may buy the Fidelity Nasdaq Composite Index ETF (ONEQ) to track the Nasdaq.

Takeaways

Of the three major stock indexes, the S&P 500 is typically seen as the best indicator for the state of the US economy. Although it may be more representative of large US corporations, it holds a diverse set of companies across many sectors. However, each index has its own strengths and weaknesses. When deciding where to put your money, it’s important to understand the pros and cons of each one.