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Beginner's Guide to Market Indices

Need help navigating the stock market? Read this.

Editor's note: This is a special excerpt from TheStreet.com Ratings' Ultimate Guided Tour of Stock Investing.

Every night on the evening news, you hear references to the two main stock market indices: the

Dow Jones Industrial Average

(DJI)

and the

S&P 500 Index

(SPX)

("indices" is the plural of "

index"). Now youask, "Why are they so important that we need to hear about them every single night?"

Well, think of the Dow Jones and the S&P 500 indices as big thermometers for the market. That's right; they actually take the temperature of the stock market so you know its condition.A

market index

is a group of stocks that share some common characteristics. It's an important tool, because it helps you figure out how your stock is doing compared with its peers. So you've got to use the right one to take your stock's temperature. Let's start by looking at the various thermometers, or indices, that are available.

For example, the S&P 500 is a group of 500 stocks chosen by Standard & Poor's because they have common characteristics, such as their size and popularity, and make up a good representation of the entire stock market. So if you want to know if a stock performs better, or worse, than the overall market, you check this index. You also may check "The Dow," because this index is made of stock from the30 largest U.S. companies, which drive the economy, and therefore, many forecasters believe, reflect a pretty accurate picture of the market.

Two

exchange-traded funds (ETFs) that track the performance of the Dow Jones and the S&P 500 are the

Diamond Trust, Series 1

(DIA) - Get SPDR Dow Jones Industrial Average ETF Trust Report

and the

SPDR ("Spider") Trust, Series 1

(SPY) - Get SPDR S&P 500 ETF Trust Report

.

If the indices appear to be enjoying a positive return on a regular basis and the economic news is sunny, the stock market is enjoying prosperity. But if, on a regular basis, the indices are showing trouble night after night, you may want to investigate where the trouble is coming from. Remember, a down market can pose a buying opportunity, or it could be a warning sign of more to come.

You have to investigate further and find out if the reason is temporary or here to stay. That's when investors use additional economic information from several sources to investigate. Much investigation involves looking at different aspects of consumer spending, which drives two-thirds of the U.S. economy. These bits of the puzzle can offer clues about how your stock may do under these conditions.

Check the Benchmark

Just as it's smart to check prices when you're ready to go shopping, it's smart to compare performance when you're ready to shop for stocks. You can do this by comparing the performance of the stock you're interested in with the performance of the stock's market index.

Let's say you went shopping for a pair of hiking boots before you headed into the jungle. You'd be interested in the price of the boots, but you'd be even more interested in how comfortable they were on your feet -- in other words, their performance.

A market index compares to the average level of comfort of all hikingboots (or maybe the 15 styles you tried on). If you decide to buy L.L. Bean boots,you might compare the comfort level of L.L. Bean's boot to the comfort level of allthe boots you tried on to decide if L.L. Bean is more or less comfortable (meaning, if the boots perform better or worse).

Each index is made up of a group of stocks that have some shared characteristics. Soif you're considering a particular stock (or boot), you compare its performance to theaverage performance of its index (the group of 15 boots you tried on).

Make sense? Market indices are also called

TheStreet Recommends

benchmarks

, because they you compare individual stocks against them to get an idea of how good or bad they are.

What are some of the shared characteristics of an index or group of stocks? Theyinclude:

  • Company size
  • Stock liquidity
  • Industry ranking
  • Diversification

Company size, for instance, is one important characteristic. Why is it important?

Large companies -- "large-caps," whose total stock is valued at $5 billion or more inthe stock market -- usually have greater access to alternative sources of money tosupport their growth. "Small-cap" companies, whose total stock circulating in themarket ranges from $250 million to $1 billion, may have trouble borrowing moremoney or issuing more stock in a time of need. Mid-cap stocks are in between in size.

On the other hand, large corporations are typically more stable than small companies,but their growth prospects are usually more limited because they're alreadylarge and don't typically have as much room to grow.

An index's defining characteristic, or characteristics, causes benchmarks to vary according to the characteristics of the stocks that comprise it. Let's take a closer look at each of the indices.

Define Your Index

The S&P 500 Index:

If you're interested in buying stock from a "large-cap" company, meaning companies with the most money circulating in the stock market ($5 billion or more), this is the index you compare it to.

This index, the most widely known, and widely regarded, benchmark of the U.S. equities market, compares the performance of a representative sample of 500 "large-cap" companies in leading industries of the U.S. economy. The S&P 500 is maintained by the S&P Index Committee, whose members include economists and analysts. The committee rates stocks based on how big they are, how liquid, or available their assets are, their rank in their industry, and how diversified they are. The S&P 500 is frequently used as the standard of comparison in determining a stock's investment performance.

The DJIA, or Dow Jones Industrial Average.

If you want to buy one of the "blue-chip" stocks, which are known for their ability to make money and pay dividends to shareholders, then this is the index to compare it to.

This index measures 30 "blue-chip" stocks, which get their fancy name from thecompanies they represent. These are large, creditworthy companies traded in theU.S., which are famous for their quality and the wide acceptance of their productsand services. By studying these companies, many believe you can get a good pictureof how the market as a whole is performing.

This index, prepared and published by Dow Jones & Co., is one of the oldest of allthe market indicators. The companies within the Dow are widely held by individualsand institutional investors. The Dow's 30 stocks represent about a fifth of the $8trillion-plus market value of all U.S. stocks, and about a quarter of the value of stockslisted on the New York Stock Exchange. Although there are now dozens of alternatives, the Dow is still the index financial professionals instinctively check first to see how "the market" is doing. It has a wide following among investors and is wellknown by even those who don't invest.

NASDAQ Composite Index.

If you're looking for an index that contains companies whose common characteristic is size, or "market capitalization," measured according to the total dollar value of all outstanding shares, check out this index.

The NASDAQ Composite Index looks at the market capitalization of both domesticand international stocks. Because it is so broad-based, and evaluates more companies (over 4,000) than most other stock market indices, the NASDAQ is also widely followed and quoted among the major market indices.

Russell 3000 Index.

If you're looking at a stock from a new and growing company, this is the index to compare it to.

The Russell 3000, which represents 98% of the U.S. market, provides a barometerof the broad market and is revised annually to include new and growing equities.

Russell 2000 Index.

If you're looking at stock from a "small-cap" company (a company with less than $1 billion in the stock market), this is the index to compare it to.

The Russell 2000, which includes the smallest 2000 securities in the Russell 3000, offers investors access to "small-cap" companies. Like the Russell 3000, this index is also revised annually.

The Dow Jones Wilshire 5000 Index.

This index, the largest of the indices, measures the performance of nearly all U.S. companies. This means you could compare any stock to this index, especially those that don't have any of the characteristics of the above indices.

Next: Diversifying Your Portfolio. To get a head start, click here.

This article was written by a staff member of TheStreet.com Ratings.