What a stock market index does and doesn’t tell us

However you watch the news, there is no getting around financial reports. With very serious faces, newscasters will tell you about the latest performance of the NASDAQ or Dow. We are told that this information should concern us and that it provides an overall picture of the economy’s health.

Well, while those reports are important, it’s good to be aware of how the final number is calculated and what it really means.

First off, we need to recognize that the Dow, NASDAQ, and S&P are each called an “index”, which means each one is a made up of a group of specifically-chosen stocks. The movement of those stocks up or down is what determines the final number given. So the indices don’t represent the WHOLE market, just a very small section of it.  For example, the Dow is only comprised of 30 stocks, and while those are very influential stocks, it’s good to remember that we are still only talking about 30 companies.

Second, the way that these numbers are calculated doesn’t always line up with common sense. The Dow Jones average is calculated by adding up the share prices of 30 of the largest companies traded in the stock market and then this total is divided by a number that is supposed to account for any irregularities.

But there are some problems with that number. First, it only reflects the prices of a company’s shares, and ignores its size. So a smaller company with high share prices affects the number more than a much larger company with lower share prices. In other words, the health of a smaller company weighs more than the health of a larger company, giving inaccurate results when looking at the whole. And that number is not adjusted for inflation.

So a stock market index can give you an idea of large trends and overall health for large sectors of the economy, but it is not a magic bullet to compare economic health over the years and it shouldn’t be the determining factor for the investment decisions you make.



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