Invest in market indexes: What they are and how they work

written on September 24, 2021

A quick glance at the financial news will surely have popular indexes like the Dow Jones, S&P 500 or Nikkei 225 mentioned. Often evoking the impression that they represent the pulse of the market, do you truly know what they are and what purpose they serve?

Market indexes are a group of stocks or other asset classes that track a slice of the financial market, be it a specific industry, region, exchange or the global market as a whole. For instance, the Nasdaq Composite Index has an abundance of technology stocks, so by looking at the index’s performance, we could gain insight as to the tech sector’s overall health. In this manner, investors can track securities easily just as they would track a single stock, enabling them to compare current and past price levels to calculate market performance.

At times, indexes can also provide a quick snapshot of the overall stock market’s financial health and even that of the wider economy.

How are market indexes compiled?

Indexes are formed by selecting a group of companies whose shares are listed on a public stock exchange and while indexes may have hundreds, if not thousands of stocks, not all are included equally. Shares are allocated via what is known as index-weighting, which takes place one of the following three ways:

  • Market capitalisation-weighted – one of the most common weighting strategies, as its name implies, market cap-weighted indexes such as the S&P 500 give more weight to larger companies with higher market cap. This is why Apple’s weighing in the S&P 500 is 7.1%.
  • Price-weighted – this gives weight to stocks with the highest share price. So in the Dow Jones Industrial Index, UnitedHealth Group (UNH) with a price of over $400 per share is weighted more than Cisco Systems (CSCO) whose stock is priced at around $55.
  • Equal-weighted – these types of indexes weigh each stock at the same level, regardless of stock price.


Companies join or are dropped from an index depending on whether their market cap increases or falls, with companies reviewed periodically to make sure that they qualify and can carry on being listed.

How do indexes go up and down?

At the very basic level, the overall performance of individual stocks will affect the index. As expected, stocks with a higher weighting have a greater influence as to how the index moves, however, many other factors like political events or trade and economic performance announcements can also impact market indexes. So if an index is mostly based on U.S. stocks, then economic data on the country’s economy, such as unemployment rates, inflation, treasury yields and so on, will affect its price.

Is there a difference between a stock index and the stock exchange?

Novice investors often believe that a stock index and a stock exchange are the same thing, using the two terms interchangeably. Yet, there are differences between the two. For instance, some stock indexes track a specific stock exchange but stocks exchanges do not track indexes. The Nasdaq is a stock exchange with a physical presence in New York City, where traders and other individuals can visit in person. The stocks traded on the Nasdaq exchange can be indexed, like the Nasdaq Composite Index, which includes almost all the stocks listed on the Nasdaq exchange, whereas the Nasdaq-100 Index, is an even more specific index that tracks the 100 largest non-financial companies traded on the exchange.

The below table outlines some of the main differences between the two.

Stock index  Stock exchange 
A collection of securities that replicate a sector or an industry. An organisation with a physical location, such as a building, where a collection of securities can be traded. 
Can be bought and sold Is defined by the stocks traded at the exchange 
Can track a stock exchange  Can be visited in person 

What are the major stock market indexes?

According to the Index Industry Association (IIA), there are more than three million stock and bond market indexes, while the U.S. alone has thousands of them. Whereas some are well-known and closely followed, others are more popular among financial professionals rather than the general public.

Here is a brief overview of just some of the most popular market indexes across the globe.

Standard & Poor’s 500 Index

Established in 1957 and more commonly referred to as the S&P 500 or simply, the S&P, this is a market capitalisation-weighted index of the 500 largest U.S. publicly traded companies. It measures the stock prices of these companies and adjusts companies’ market caps by the number of shares available to the public for trading. So if a company has 2 million shares held by shareholders and the current stock price is $5, then the company’s market cap is that of $10 million.

Apart from their market cap, to be included in the S&P 500 companies must also be based in the U.S., be listed on an eligible U.S. exchange, be structured as a corporation and offer common stock, as well as have positive earnings. Some of the companies that make up the S&P 500 include Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Facebook (FB), Tesla (TSLA) and others.

All companies combined account for about 80% of all the publicly-traded stock in the U.S. and seeing that it represents the largest publicly traded companies, the S&P is one of the most widely quoted American indexes, often viewed as a measure of how well the stock market is performing overall.

Dow Jones Industrial Average (DJIA)

Also known as the Dow 30, the Dow Jones Industrial Average is a stock market index that tracks 30 large and publicly-owned blue-chip companies that trade on the New York Stock Exchange and the Nasdaq. This means that the companies that make up the index have consistent stable earnings, some of which include Disney (DIS), Boeing (BA), Coca-Cola (KO), Walmart (WMT) and others. Unlike the S&P 500, the DIJA is a price-weighted index, which means that companies with higher stock prices have greater weight in the index’s calculation, while it takes into account historic stock splits, dividends and other changes.

The second-oldest index in the U.S. after the Dow Jones Transportation Average, the DIJA was created by Charles Dow and his business associate Edward Jones back in 1896 so that it could serve as a representation of the U.S. broader economy’s health. Despite its name, today, several of the companies that make up the index operate in sectors other than heavy industry.