How Much Should Stock-Market Indexes Influence Investors?

Dow and other indexes can be useful, but analysts say don't use them as a proxy for entire stock market

By , Staff writer of The Christian Science Monitor

HOW often have you turned on the radio and heard a news report like this: ''There is some unease on Wall Street today, with the Dow Jones industrial average sinking 12 points in noon trading.'' To what extent should the average investor be influenced by day-to-day gyrations in the popular and widely publicized Dow Jones industrial average, or any other stock-market price index? If all indexes are heading down decidedly, it clearly indicates a tumble in stock- market prices. But the meaning of a swing in a single index depends on what the particular index measures, the experts say. ''The basic problem [in financial analysis] is that many people are using the Dow Jones industrial average as a proxy for the stock market in general,'' says Larry Wachtel, a vice president for investment house Prudential Securities Inc. Monitoring the Dow, and other indexes, can be a ''useful guide'' to what's happening with stocks, Mr. Wachtel says. Obviously, ''when all major indicators are collapsing,'' the market is in deep trouble, he notes. Or, when all indexes are rising, that spells ''a bull-market trend.'' But watching the Dow on a short-term basis can lead to ''erroneous impressions'' about the direction of financial markets, he says. ''The Dow is comprised of 30 large blue-chip industrial stocks. But because of the way the Dow is structured, a movement of just 1 point in a Dow-listed stock translates into a movement of around 2.5 points in the overall Dow average. Thus, if 29 components [companies] in the Dow remain unchanged, and just one company, say IBM, goes down by 5 points, the Dow average drops by 12 points,'' Wachtel says. ''If IBM goes up 5 points, and the other 29 components remain unchanged, the Dow rises 12 points.'' Oldest index ''The Dow is important because it is the oldest index and has much historic data. But the Dow only tells part of the market's story. There are many averages [indexes], and each one tells us about a different facet of the stock market,'' Wachtel says. He suggests that it may be just as important for an average investor to watch the number of stocks increasing in price (advances) and the number dropping in price (declines) as the Dow average. ''Are more stocks advancing forward [in price] in a given day of trading than are declining? That means a bull market, at least that day. Or are more stocks declining? That means a bear market that day,'' Wachtel says. If there is a continuous pattern of advances or declines, that suggests a broader trend that should probably be factored into the investor's own decisions regarding trading, he adds. A clearer picture ''Market indexes help tell you where the market is going. But the Standard & Poor's 500 Stock Index - because it tells you about what is happening to 500 large industrial companies - gives you a clearer picture as to what is happening with the broader market than just the 30-stock Dow,'' says Arnold Kaufman, editor of The Outlook, a market newsletter published by Standard & Poor's Corp. ''Investors should make an effort to understand the indexes, and perhaps look for an index that makes the most sense for their particular type of investing,'' says John Markese, president of the American Association of Individual Investors (AAII) in Chicago, a national group of small investors. ''One should learn about each index's components and its quirks,'' he says. The Dow, for example, is calculated, or weighted, by the price of each of the stocks that make up the index. The S&P 500 is calculated, that is, weighted, by the value of all the shares of each company (market capitalization) of those stocks included in the index. ''Some indexes tend to exaggerate trading movements,'' Markese says. Thus, he says, the Nasdaq 100 is not a good indicator of small stocks, because it is dominated by high-tech companies. The movement of just a few high-tech companies can sharply alter the index. ''A better measure of what's happening with small stocks would be the Russell 2000 index, but most people don't even know about that one,'' he says. Here are some of the best-followed stock-market indexes: * Dow Jones industrial average: 30 blue-chip stocks, based on price. That is, higher-priced stocks have traditionally had more impact on the Dow than lower-priced stocks. First established in 1884, it has been published in a more modern form since 1897. * Standard & Poor's 500 Stock Index: 500 stocks of large industrial companies. Introduced in 1957, this is generally considered the most comprehensive guide to industrial America, although it tends to be less noted in news reports than the Dow. * The Nasdaq 100: Based on 100 smaller companies, but not necessarily the smallest US companies. It is dominated by high-tech firms. * The Nasdaq Composite Index: Includes 4,945 companies both large and small and is considered one of the broadest measurements of the United States business community. However, it includes many high-tech firms. Watching this index can be useful in gauging price changes for new and innovative companies. Nasdaq is a success story in itself, having nudged aside the American Stock Exchange in the last decade to become the second-largest stock market after the New York Stock Exchange in the US. * The Value Line Composite Index: Measures more than 1,000 stocks, many of them slightly speculative in nature. Analysts consider it a good index for monitoring growth stocks. * The Russell 2,000 index: Covers 2,000 smaller companies. Standard & Poor's investors, Kaufman says, can profit from the gyrations in market indexes by buying into stock-index mutual funds linked to a specific index (usually the S&P 500). The asset value of the mutual fund rises or falls, reflecting the movement of the index. Thus, if the index is up for the year, so too, presumably, is the particular mutual fund. Finally, Kaufman notes, while indexes can often diverge among themselves, they tend to come out at the same place over time. When the market crashes, so too, usually, do all the indexes. And when the market roars upward, so do all the indexes.

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