Stock market indexes are by far the most widely used tools in making investment decisions. But many investors take for granted what market indexes are and the many roles they play within their portfolio strategy and throughout the financial ecosystem.

In this article, we’ll take apart the core structure of an index and explain why they are such a trusted and integral part of the financial world. But first, we’re going to examine exactly how central market indexes have become to investors and the financial world at large, and how their ubiquity goes unnoticed and unappreciated.

Enter The Market

Let’s start with a question: what are people referring to when they talk about “the market?” As in, “the market gained 50 points and finished the day up about two percent?” Or, “30 percent of my portfolio is in the broad market?”

We can gather from context clues that it’s definitely a thing, not just a convenient turn of phrase. We can also guess with confidence that “the market” probably refers to some aspect of the stock market, specifically the U.S. equities market. This means that the daily financial recaps you might hear on the radio around 5 o’clock are reporting on the overall performance of U.S. stocks.

But how? There are thousands of stocks traded on just the major exchanges like the New York Stock Exchange (NYSE) and Nasdaq, and they all move independently from one another (for the most part, at least). And that doesn’t take into account other exchanges like the American Stock Exchange or BATS Global Markets, which have a whole array of other stocks in addition to those that appear on NYSE or Nasdaq.

So it’s unlikely that “the market” is taking into account the entire set of equities for sale to investors.

Maybe it’s an average of the stocks available to trade, and perhaps just on the major exchanges? But then that would also include thousands of stocks that don’t move much at all in a single day, which would make even modest, one percent moves in “the market” almost impossible. Perhaps the average is weighted based on each stock’s market cap?

We’ll pause this exercise for now. Obviously, ferreting out what “the market” is in this manner, through assumptions or half-remembered investment concepts, isn’t helping us define “the market.” Even though the words seem familiar, things get fuzzy when we actually trying to pin them down.

But this is how a large majority of people interact with their investments on a daily basis, pooling their money in products from gigantic financial monoliths that act as a black box: money goes in and, depending on certain stocks moving the right way and a set of rules put in place by some anonymous money managers, a hopefully greater amount of money comes out.

But what is “the market” and, most importantly, how does it relate to all of those fancy financial products that make up your portfolio?

Enter the Index

To break the suspense, when the term “the market” is used in casual English, it’s generally referring to the S&P 500 index, a collection of 505 stocks (I know, finance…) traded on either NYSE or Nasdaq that cover an array of industries from across the 11 sectors that make up the economy.

The stocks that compose the S&P 500 index are selected based on several criteria set by S&P Dow Jones Indices LLC, which owns and maintains the index. In order to be included, a company must:

  • be a U.S. company,
  • have a market cap of at least $6.1 billion,
  • make at least half of its outstanding shares available for public ownership
  • have reported positive revenue in the previous four quarters
  • maintain an average monthly trading volume of 250,000 shares and,
  • achieve an annual dollar value of shares traded that is greater than the value of all the publicly available shares (the stock’s float-adjusted market cap).

Stocks within the S&P 500 are evaluated twice a year to see that they meet all of these benchmarks. While meeting the criteria does not guarantee inclusion, each one is necessary to remain in the index once selected.

To calculate the index value, S&P takes the sum value of all the publicly available equity in those companies at any given moment—their float—and divides that by a constantly changing proprietary calculation (about 8.9 billion). The result is a number intended to reflect the overall performance of the stock market. This is how the S&P 500 gained its “the market” moniker and why it is used as a shorthand for the overall state of both the stock market and the U.S. economy as a whole.

That’s the “the market.”

But it’s not the only market index that tries and mimic the entirety of U.S. private business. The Dow Jones Industrial Average attempts the same feat, as do the Russell 3000 index, and the AMEX Major Market index. But they all do it differently.

And those are far from the only kinds of market indexes out there. The S&P 500 is a vendor index, which means it’s formed by a company not directly affiliated with the exchanges that list the stocks it tracks. Another widely-followed market index, the Nasdaq Composite, is created by Nasdaq, Inc. and includes most of the large, publicly traded companies listed on the exchange. NYSE has a similar index for its own equities, as do most exchanges.

The point is, there are literally hundreds of market indexes, and each one has its own rules, requirements, goals and owners.

The Beauty of Indexes

The impetus behind the creation of a market index is to capture a certain theme or aspect of the global economy (or the global economy itself). Each market index is a microcosm, and the rules that govern their structure are put in place to make sure the index performs consistently against the theme it’s meant to represent.

For example, the S&P 500’s theme is a scaled version of the U.S. economy, while the theme of the MSCI World index is global exposure to large- and mid-cap companies from 23 developed economies. The composition and requirements for inclusion in a given market index are tailored modified to make sure that they best reflect their original intent.

This is one reason why market indexes are so popular as an investment tool, they are consistent. That consistency is the result of the array of equity contained in each one that makes them good bellwethers for risk, as well as effective tools for avoiding it.

However, it’s important to keep in mind that market indexes aren’t magic, they’re not flawless. Each one is calculated and composed differently by different people with different outlooks on the stock market and the world. The S&P 500 is not a 1:1 replica of the stock market or the actual economy, it’s simply one of the better simulacrum available.

The best market indexes are created and maintained by some of the smartest minds in finance. But they all have biases and blind spots built in. The best they can do is perform consistently, but each one will perform uniquely, even if they attempt to do the same thing.

That’s important to keep in perspective. Because the summary-style information a market index provides investors can be useful, it’s easy to lose sight of the fact that they don’t always reveal the whole picture.

While the broad insight market indexes lend investors can be an invaluable resource for research, the overwhelming reason why there are tens of hundreds of market indexes currently operating is because they can work as the basis of an investment strategy. Other companies take advantage of that groundwork by licensing the structure of a market index for use in products they can then sell to everyday investors.

Like you.

Me, myself and I and a World of Index Funds

Which brings us to index funds—as well as a large swath of exchange traded funds (ETFs). Because you can’t invest directly in a market index, the holdings in these investment products are each modeled to perform like the index to which it’s pegged. Although the allocation of those holding and the overall objectives of a particular fund will vary, even between funds derived from the same market index.

Take the Vanguard 500 Index Fund Investors Share and the Schwab S&P 500 Index Fund. Both of these indexes take their holdings from the S&P 500, but Vanguard and Charles Schwab each undertake their own methodology, which causes them to perform differently. This is why you’ll often hear the importance of checking a investment firm’s prospectus, which provides all the details about how a fund is managed and what its objectives are.

But what you don’t often see is a suggestion to review how and why the index a fund is based on is created. This is because it’s assumed that indexes are neutral, that they do what they say they do because that’s how they were built.

However, we know that indexes are only built to be self-consistent, and the rules holding them up aren’t immutable.

As an example, we can look again to the S&P 500, the most widely followed and heavily invested in index in the world. Prior to March 2017, it had a different minimum market cap for inclusion, $5.3 billion as opposed to $6.1 billion. A result of which was that a few stragglers were knocked off the index entirely. And that is only one index, with one set of rules.

That’s why all this is important for investors to understand. As market indexes become an even greater force within the stock market, and more people put their faith and financial future entirely in the makeup of market indexes (and the products derived from them), it becomes essential that investors understand exactly how and why they are created.

So, the next time you hear someone talk about how “the market” did that day, or why the Dow Jones is going to tank next month or that a new green energy ETF is projected to grow by 100 percent in the next year, consider the underlying risk and selection logic going on beneath those assessments and avoid the pitfalls of putting all your money into an index you only half understand.