How Stock Market Indexes Are Calculated and Why They Matter

Comparing Major Stock Market Indexes: Which One Should You Follow?Understanding stock market indexes is one of the first steps to becoming an informed investor. Indexes summarize the price movement of a group of stocks, giving a snapshot of market sentiment, sector performance, or the economy as a whole. This article compares the major stock market indexes, explains how they’re constructed, highlights strengths and limitations, and helps you decide which one(s) to follow based on your goals.

What is a stock market index?

A stock market index is a statistical measure representing the performance of a selected group of stocks. Indexes can be broad (representing an entire market), sector-specific, or focused on size (large-cap, mid-cap, small-cap). Investors use indexes as benchmarks for portfolio performance, as the basis for index funds and ETFs, and as indicators of market or economic trends.

Major indexes commonly followed

• S&P 500 — Broad U.S. large-cap benchmark representing 500 leading publicly traded U.S. companies across sectors. Market-cap weighted.
• Dow Jones Industrial Average (DJIA or “the Dow”) — Price-weighted index of 30 large, established U.S. companies. Long history and media prominence.
• Nasdaq Composite — Market-cap weighted index that includes all stocks listed on the Nasdaq exchange; heavy tech and growth-company bias.
• Russell 2000 — Market-cap weighted index of approximately 2,000 small-cap U.S. companies; used to track small-cap performance.
• MSCI World / MSCI All Country World Index (ACWI) — Global indexes covering developed markets (MSCI World) or both developed and emerging markets (ACWI). Market-cap weighted and widely used for international exposure.
• FTSE 100 / STOXX Europe 600 — Examples of regional benchmarks: FTSE 100 (UK large caps) and STOXX Europe 600 (broad European exposure).
• Nikkei 225 / TOPIX — Major Japanese indexes; Nikkei is price-weighted (225 stocks), TOPIX is market-cap weighted and broader.

How indexes are constructed (brief)

• Weighting method:
  • Market-cap weighting (most common): companies weighted by market capitalization; larger firms have more influence.
  • Price weighting (e.g., Dow): stocks weighted by share price; high-priced stocks have outsized effect.
  • Equal weighting: each constituent has the same weight, emphasizing smaller constituents more than cap-weighted indexes.
  • Fundamental weighting: weights based on fundamentals (sales, earnings, dividends).
• Selection rules: indexes use specific eligibility rules (market cap thresholds, liquidity, free-float, domicile), and committees periodically rebalance constituents.

Key differences and what they mean for investors

• Exposure and representativeness:
  • S&P 500: broad exposure to large-cap U.S. economy, good benchmark for U.S. equity market.
  • Dow: narrower, price-weighted view of large industrial and consumer names, more of a historical media barometer than a comprehensive market measure.
  • Nasdaq Composite: tech- and growth-heavy, more volatile and growth-oriented.
  • Russell 2000: small-cap exposure, tends to be more sensitive to domestic economic cycles and risk appetite.
  • MSCI ACWI / World: global diversification, reflects developed and/or emerging markets beyond the U.S.
• Volatility and risk:
  • Tech-heavy indexes (Nasdaq) often show higher volatility and higher long-term growth potential.
  • Small-cap indexes (Russell 2000) are typically more volatile and carry greater idiosyncratic risk.
  • Broad global indexes may reduce single-country concentration risk but introduce currency and geopolitical factors.
• Return drivers:
  • Large-cap indexes are driven by a handful of mega-cap companies in cap-weighted indexes.
  • Equal-weighted versions shift returns toward smaller constituents and can boost smaller names during broad rallies.
• Liquidity and tradability:
  • Major indexes underpin highly liquid ETFs and futures, making them practical for investing and hedging.
• Tax and currency considerations:
  • International indexes introduce currency risk; tax treatment varies by domicile and fund structure.

Which index should you follow? (Decision guide)

Consider these investor objectives:

• Benchmarking a U.S. portfolio or seeking broad U.S. exposure: follow the S&P 500. It’s the industry standard for U.S. large-cap performance.
• Want a pulse on tech and growth sectors: follow the Nasdaq Composite (or Nasdaq-100 for a concentrated large-cap tech view).
• Interested in long-run historical market sentiment or media coverage: follow the Dow for its simplicity and historical role, but be cautious using it as a sole performance benchmark.
• Seeking small-cap exposure or a gauge of domestic risk appetite: follow the Russell 2000.
• Looking for international diversification: follow MSCI World or MSCI ACWI (ACWI for both developed and emerging markets).
• Need regional focus (Europe, Japan, UK): follow region-specific indexes (e.g., STOXX Europe 600, Nikkei 225, FTSE 100).

Practical tips for using indexes

• Use multiple indexes: Track a U.S. large-cap index (S&P 500), a global index (ACWI), and a small-cap index (Russell 2000) to get a fuller picture.
• Compare your portfolio against an appropriate benchmark: match by geography, capitalization, and investment style.
• Watch sector composition: two indexes with similar names can differ substantially in sector weights (e.g., S&P 500 vs. Nasdaq).
• Consider equal-weighted alternatives if you want reduced concentration in mega-cap stocks.
• Remember index returns don’t account for fees, taxes, or the real-world constraints of replicating the index exactly.

Limitations and pitfalls

• Indexes are backward-looking summaries and can be influenced heavily by a few large constituents.
• Price-weighted indexes (Dow) can distort perceived market movements.
• Tracking only one index can create blind spots—regional, sector, or factor risks may be missed.
• Overreliance on headline indexes promotes “index hugging” — thinking the market equals the S&P 500 even when other segments diverge.

Quick comparison table

Conclusion

No single index is objectively the “best” to follow—each serves different informational and investment roles. For most investors seeking a simple but representative view of U.S. equities, the S&P 500 is the standard. If you want tech-heavy growth exposure, monitor the Nasdaq; for small-cap trends, watch the Russell 2000; and for global diversification, check MSCI ACWI. Use a combination of indexes that matches your investment horizon, risk tolerance, and the geographic/style exposure of your portfolio.