Indexes in securities markets are representations of various combinations of assets traded in the market, such as stocks, mutual funds, and bonds. Due to the high number of securities traded, numerous permutations can create market indices.
Because of the flexibility that comes with creating indexes, the number of indexes has grown greatly, and they are currently more than the traded stocks on NYSE. Many investors prefer trading in indexes because of their perceived in-built diversity. This saves them the trouble of having to research the performance of individual stocks and picking them one by one. This also explains the spike in the popularity of ETFs.
An index works by tracking the performance of the individual stocks in it. Once that is done, the index’s performance is computed based on the weighted contribution of the stocks. Therefore, when these stocks register an average improved performance, the index’s performance improves and vice versa.
An index, therefore, compresses the performance of its component stocks into one. The index performance is computed in a manner that ensures that it is a true representation of the gains and losses made by its component stocks. Therefore, an index can give traders and investors a good representation of the performance of the wider market.
NASDAQ Composite Index
Using the Ticker: IXIC, the NASDAQ (National Association of Securities Dealers Automated Quotients) composite index tracks about 3000 stocks that are listed on the NASDAQ exchange. It is the largest of the big three market indices, with the other two being Dow Jones Industrial Average and S&P 500.
The composite index should not be confused with the other index in the Nasdaq Exchange, the Nasdaq 100 Index. The latter tracks the top 100 stocks by company market capitalization, while the composite index consists of more than half of the companies listed on the stock exchange.
This index’s unique attribute is the fact that most of the stocks in it are of technology companies. In addition, the index’s large number of stocks effectively means that it incorporates the three different sizes of companies, namely small, medium and large market-cap companies. Its performance, therefore, gives a better representation of the overall stock market than other indices.
Due to the comparatively higher performance of tech companies in the last ten years, Nasdaq has performed better than both S&P 500 and DJIA during that period.
Dow Jones Industrial Average (DJIA) Index (ticker: DJI)
The Dow Jones Industrial Average is an index that tracks the performance of the 30 largest stocks in the United States industrial segment. Despite its small number of constituent stocks, the index has a high market capitalization, with its stocks representing about a quarter of the value of all listed stocks in the United States.
This emphasizes the fact that the index tracks some of the most valuable companies. This makes it a popular choice for investors. Because it tracks companies with very high large market capitalizations, the DJIA has in recent times grown at a significantly lower rate than the Nasdaq Composite and the S&P 500.
This is explained by the fact that the companies it tracks have grown so large that they are left with little room for growth. For example, the companies have the largest market shares in their respective segments, making it difficult for them to significantly expand their markets.
The difference between DJI and Nasdaq
- The difference in the formula for computation: The formulas used in the computation of the two indices are significantly different. In calculating the Nasdaq Composite, the stocks are weighted according to their market capitalization.
Therefore, a company with higher market capitalization carries more significance than one with a lower market cap. On the other hand, DJI is calculated by assigning more weight to the price per share of the constituent stocks. In this case, for example, a firm whose shares sell at $50 each will contribute more towards the index than one whose share price is $35.
- Different mechanisms for the inclusion of stocks: As mentioned above, the Dow Jones Industrial Average is computed from the 30 largest companies by market capitalization. In contrast, the Nasdaq Composite is an exclusive club for companies listed at the Nasdaq Exchange. The Nasdaq is also dominated by tech companies, unlike the Dow Jones.
- The number of stocks: By the sheer number of stocks, DJI is a small fraction of the Nasdaq Composite, considering that it has only 30 stocks, while the Nasdaq has about 3,000.
- Impact of constituent stocks: Due to the small number of stocks in the Dow, the index feels the impact of the price action of an individual stock at a greater degree than the Nasdaq Composite. For perspective, 50% of the index’s value is held by the ten largest stocks in it. Some investors consider this aspect as a risk factor.
The Dow Jones Industrial and the Nasdaq are two of the most significant stock market indexes. Their main points of divergence are in the constituent stocks and how the index is computed. These factors significantly affect the indices’ performance and should, therefore, inform your decision-making on which one to invest in.