Choosing the Best Stock Market Index
Daily movements in the stock market are now routinely tracked by average households. Employer-sponsored 401(k) plans fed the great bull market of the '90s and made headaches for workers who saw their retirement funds go sharply up and then sharply down. Individual investors typically track the Dow Jones Industrial Average of 30 top stocks, largely because it's the traditional choice of the popular press.

But stock activity varies by market. Depending on which particular index you were quoting in 1999, you might have described the equity market as phenomenal (NASDAQ composite up 85 percent) or simply good (DJIA up 24 percent). Conversely, the Nasdaq fell 39 percent in 2000 and 21 percent in 2001, while the DJIA only fell 6.2 and 7.1 percent, respectively. Changes have been even more dramatic in more recent years. For instance the Dow increased 25.3 percent in 2003 while the Nasdaq composite surged 50 percent. Depending on the market measured - high tech, small cap, large cap blue chip - large differences are the norm.

Individual investors are often surprised to see that the gains or losses in their portfolio don't typically match up with the Dow, or that the volatility of their portfolio is dramatically greater. But remember, the stock market is more than just 30 stocks! Investors need to monitor other benchmark indexes to more accurately gauge the performance of their own portfolios.

Stock market indexes abound. We will cover some of the key and most readily available. You may be surprised to learn that they don't all move in the same direction or by the same magnitude. You may also find a particular index, other than the DJIA, that better aligns to your own portfolio.

The Dow Jones Family
The Dow Jones Industrial Average tracks 30 large U.S. companies that as a group are considered representative of the nation's economy. The average includes industrial companies such as General Motors and Minnesota Mining & Manufacturing and also non-industrial companies like Walt Disney and Wal-Mart. The Dow is designed, not always successfully, to represent broad economic trends. During the millennium's technology boom, the words "old economy" stuck to the Dow. During the technology bust, the insult was less often repeated.

The Dow Jones Transportation indexes measures stock prices of 20 railroad, airline and trucking companies. The DJTI is considered a leading indicator of changes in the DJIA. The Dow Jones Utilities Index measures stock prices of 15 utility companies, which tend to be more sensitive to changes in interest rates than the Industrials or Transports. Utility companies have historically offered high dividend returns.

The S&P Family
The DJIA may be more widely quoted, but the S&P 500 index is a more comprehensive measure of market activity. Not chosen strictly for their size, the 500 are chosen because they are leading companies in leading U.S. industries. Eighty-seven percent of the companies in the index are listed on the New York Stock Exchange (NYSE) and only 13 percent on the Nasdaq. This index is weighted by market value (stock price times the number of shares outstanding) rather than (stock) price only, like the Dow. In contrast to the Dow, where companies with high stock prices have greater influence on the index change, companies with larger market capitalization have greater influence on changes in the S&P 500.

The S&P 500 can be divided into various groupings, including economic sectors. These are: energy, materials, industrials, consumer discretionary, consumer staples, health care, financials, information technology, telecommunication services, and utilities. These latter classifications are typically used by financial professionals to target sectors in which to invest over differing stages of the economic business cycle.

In addition to the S&P 500, Standard & Poor's also publishes the S&P Midcap Index and the S&P Smallcap Index. These are each calculated in the same way as the S&P 500. Each of these indexes represent companies with smaller market capitalization than those in the 500 index and can also be subdivided into economic sectors.

Nasdaq Stock Market Measure
The Nasdaq composite index is cap-weighted and measures the performance of this stock market. In 2005, about 3,300 companies were listed. This market, which tends to list fast growing technology companies, is home to smaller stocks than the New York Stock Exchange. Though Microsoft and Intel are two great listings of the index, it is more usual to see small, lesser-known names.

The Nasdaq market does offer performance by market sector such as industrials, financials (banks, insurance and other financial industries), transportation, computers and biotechnology. Also the NASDAQ-100 (QQQ) is traded on the American Stock Exchange.

Private Companies Compile Index Information
The composite indexes from the various exchanges don't tell a complete story. Looking at the Dow and the S&P 500 can be misleading if investors have portfolios with small cap (small capitalization) stocks or a different mix than those offered by these blue chip indexes. Private investment analysis firms have developed a variety of indicators to be used as benchmarks. The Russell 2000 index and the Wilshire 5000 are two measures that attract wide interest among investment professionals, individual investors, and government policymakers.

The Russell 2000 is the best-known smallcap index. It includes 2000 companies (hence the name). About half of the companies are listed on the NYSE and just under half are listed on the Nasdaq (the remaining come from the AMEX). The average market cap for companies in the Russell 2000 at its last reconstitution in mid 2005 was $664.9 million.

The Russell 2000 is widely quoted in the financial press. It is less well known that the Russell set of indexes is quite extensive. For instance, Russell compiles value-versus-growth indexes for each of its 1000, 2000, 2500, and 3000 series. It compiles mid-cap indexes as well.

The Wilshire 5000 is the broadest measure of all indexes. The number was set in 1970 when a total of 5000 U.S.-based companies were publicly listed. Now the number is more than 7000. Market professionals watch this index more closely than do individual investors or the even the financial press. Federal Reserve officials follow this index because it broadly represents the stock market.

Looking at the composition of the Wilshire 5000 by exchange, the greatest number of companies come from the Nasdaq. But by market capitalization, more hail from the NYSE.

The NYSE Arca Tech 100 Index is a price-weighted measure of 100 listed and over-the-counter stocks from 15 different industries. These include computer hardware and software development, semiconductors, networking, communications and data storage and processing. The NYSE Arca Tech 100 Index was formerly known as the PSE (Pacific Stock Exchange) Index. In September 2005, Archipelago Holdings purchased the Pacific Exchange and the Pacific Stock Exchange Tech 100 Index and in October 2005 renamed the Index the ArcaEx Technology 100 Index. In March of 2006, the New York Stock Exchange and Archipelago Holdings merged, creating NYSE Arca, and in April of 2006 the Index was renamed the NYSE Arca Tech 100 Index.

The Bottom Line
Investors might use a more comprehensive benchmark to compare their portfolio or mutual fund returns than simply the Dow Jones Industrial Average or even the S&P 500. During the great bull market, surveys of consumer expectations showed that individual investors tended to have inflated expectations of annual returns that were far removed from historical reality. Consumers were simply extrapolating the returns in the Dow or the S&P or the NASDAQ during the late 1990s. These "hefty" returns would have been less bloated if investors had watched the broader market.

If you are investing in an index fund intended to mirror the S&P 500, by all means use that as your benchmark. Otherwise, look at other measures that more accurately reflect the overall market. These will give you a better sense of the underlying performance of your portfolio relative to the total market. It will make you less likely to shift in and out just to catch the latest "hot" fund. By less shifting of funds, you will be able to reduce your transaction costs and enhance your returns in the long run.