When people talk about the market going up or down, showing a strong performance or a weak one, or turning bull or bear, they are referring to the market as seen through the lens of indexes.

Indexes work like a summary of the market by tracking the top stocks within a market. As one of the biggest factors in the performance of stocks is the health of the market, it is hard to believe that indexes have been around for less than half the history of stock exchanges. In this article we will look at the history of these investment vehicles.

TUTORIAL: Index Investing

Before the Dow
The stock market's reputation has seen highs and lows throughout its history. Its lowest point is best shown in the years following the crash in 1929 because it destroyed the value of so many people's investments.

The first 120 years of the New York Stock Exchange has to rank as the second worst low for the Dow. The mistrust of the market during this time was not as intense, but it was much more sustained. The main reason behind this low was that people involved in the market were speculating rather than investing. This wasn't entirely their fault as regulations were quite loose and whatever information you could get wasn't guaranteed to be accurate or even truthful. This, coupled with the vulture-like dealers and brokers who circled around Wall Street waiting for investors they could exploit, made the markets more volatile. There were many honest brokers, companies and dealers, but there was nothing to stem the tide of fraud flowing from the less scrupulous ones. (To read more about the NYSE, check out What is history behind the opening and closing bells on the NYSE?)

Less recognized, but equally important, was the fact that people didn't understand the market or its fractions and points. The idea of a market was still one of stalls where you could browse farmers' produce and buy your groceries. The idea of buying the performance of a company was difficult for 17th and early-18th century Americans to grasp.

Remember that most adults of this time had spent their childhoods in mines, factories and fields rather than schools. Even the elite who were involved in the market didn't fully understand it in some cases. They understood that it went through periodic ups and downs in the same vague way that a person in the hold of a ship can guess whether it is at sea or in port by the motion, but still have no idea of the size or frequency of the waves they'll encounter. Without this information, buying a stock when it was overpriced or underpriced was mostly a matter of luck.

Sticks in the Sand
Charles H. Dow, a finance journalist, unveiled the first stock index in 1896. His Dow Jones Industrial Average was an average of the top 12 stocks in the market. As this was just at the tail end of the industrial revolution, the majority of these companies were in the industrial sector (steel mills, railroads, mining, etc.). He calculated the DJIA by taking all of the stock prices, adding them together and then dividing them by the number of stocks. The number that came out of this equation on May 26, 1896, was 40.94. The range of the Dow has since been expanded. (For more insight, read Dow Theory.)

Dow thought of his average as a measure of the market's tide. Through his calculations, he was basically placing a stick at the high water mark of each wave, or trading day. If the waves kept pushing him and his stick up the beach, then the tide was rising. If he had to walk out farther each time to pick up the stick, then the tide was receding. Armed with this measure, Dow was able to see whether the market rose for a consecutive period, as with a bull market, or if it regularly fell, as with a bear market.

Dow started the Railroad Average in 1884 (now the Dow Jones Transportation Average) and the Utility Average in 1929. In 1928, it became necessary to switch the method of calculating the Dow indexes because companies were doing mergers and stock splits that warped the numbers. The Dow switched to a system of flexible divisors that change in order to keep the average from distorting from these and other complications. In this form, the DJIA is still around in 2007, but the 30 companies that make it up have much less concentration in the industrial sector. The name, however, has stuck.

S&P 500
Standard & Poor's 500 traces its roots to 1860, when Henry Varnum Poor published "History of the Railroads and Canals of the United States." Rather than being a literal history of the railroad, it was the first financial history of all the companies laying track or digging canals in the United States. Poor hoped that his book would help get information to investors outside the banking district. Its success led him to publish the Manual of the Railroads of the United States on an annual basis.

The rate at which Poor's publications sold out encouraged other companies like Standard Statistics and Moody's Manual Co. to broaden their operations beyond just railroad stocks. These three firms underwent a slow series of mergers from 1913-1941. During this process, Standard Statistics started keeping an index of 223 stocks in different sectors of the market, but had to reduce it to 90 because there was no machine or person who could match the computing challenge of updating an index containing so many companies. One of the things that distinguished this index from the more popular DJIA was the fact that it was a market-weighted average rather than price-based like the Dow. This meant that the bigger companies didn't sway the 90 as much as the top companies in the Dow did the DJIA. This more accurate measure of the overall market was not fully appreciated until much later.

Poor's company went bankrupt after the 1929 crash and was absorbed into Standard Statistics on gracious terms. The newly formed Standard & Poor's 90 Index, merely a renaming of the Standard Statistics 1926 index, was the only index that was computed daily. In 1946, Standard & Poor bought a punch card computer from IBM and was suddenly able to expand the index to 500 companies, which could be updated hourly.

See the Tech Stocks Run
In 1985, the Nasdaq introduced its own index to compete with the S&P. The Nasdaq 100 was designed as a market-weighted index that contained more companies from the technology sector - largely unmapped territory at the time. The Nasdaq itself was designed to market these stocks and it had been steadily growing in power as both the computer and the internet brought technology into people's homes.

The popularity of technology during the 1980s and '90s earned the Nasdaq 100 the third spot on the financial news reports. This increased exposure caused more investors to flock to the inflating bubble in the late '90s and, consequently, increased the damage from the tech crash. Despite its unfortunate role in the crash (and thanks to an increasingly technologically dependent world), the Nasdaq 100 continues to earn its place as one of the premier indexes in the world. (To learn more about the Nasdaq, see The Tale Of Two Exchanges: NYSE And Nasdaq and Getting to Know Stock Exchanges.)

Indexes Galore
In addition to the Dow, the S&P and Nasdaq indexes, there are hundreds of other indexes. Index funds and the passive investors who love them have encouraged the creation of an increasing number of these market-tracking tools.

The most popular after the top three are:

Sector-specific investors also have a smorgasbord of indexes to choose from.

This glut of information is largely due to improvements in disclosure, computation and, of course, the internet. Computation in particular has allowed statisticians to take as wide or narrow a swath of stocks as they please and to get the updated figures every few seconds for recalculation. The rapidity of the data and the analyses that can be conducted with it were unthinkable even 30 years ago.

How the Index Changed Investing
The impact of indexes on investing was, and continues to be, huge. On the most basic level, indexes brought transparency and a better understanding of market forces. Dow theory, pioneered by Charles Dow and elaborated upon by his predecessor, was one of the first attempts at technical analysis. Indexes have also been invaluable to contrarians, traders and momentum investors, by giving them a measure of overall market sentiment.

Most of all, indexes created a benchmark for investors and money managers to measure up against. The creation of this benchmark also encouraged a segment of the investing population to choose a less active route and settle for more modest returns, thus marking the first time in investing history where it became possible for people with little financial knowledge to control their own portfolios. There are now indexes for technology stocks, pharmaceuticals and any subset within the financial world that an investor would care to know. The challenge for investors is no longer how to get reliable market information, but what to do with it.

To read more about the history of investing, check out The Stock Market: A Look Back and How The Wild West Markets Were Tamed.

Related Articles
  1. Credit & Loans

    What SoFi's Super Bowl Ad Means for Your Next Loan

    Non-bank lender SoFi will air its first TV ad during Super Bowl 50. Here's how it's challenging big banks by providing an alternative approach to loans.
  2. Fundamental Analysis

    3 Long-Term Investing Strategies With Strong Track Records

    Learn why discipline and a statistically valid investment strategy can help an investor limit losses and beat the market over the long term.
  3. Fundamental Analysis

    5 Basic Financial Ratios And What They Reveal

    Understanding financial ratios can help investors pick strong stocks and build wealth. Here are five to know.
  4. Chart Advisor

    ChartAdvisor for February 5, 2016

    Weekly technical summary of the major U.S. indexes.
  5. Mutual Funds & ETFs

    The 5 Best US Small Cap Value Index Mutual Funds

    Find out which index mutual funds do the best at investing in small-cap value stocks for higher potential returns at the lowest cost.
  6. Fundamental Analysis

    5 Predictions for the Chinese Stock Market in 2016

    Find out why market analysts are making these five ominous predictions about the Chinese stock market in 2016, and how it may impact the entire world.
  7. Investing

    What Investors Need to Know About Returns in 2016

    Last year wasn’t a great one for investors seeking solid returns, so here are three things we believe all investors need to know about returns in 2016.
  8. Chart Advisor

    3 Charts That Suggest Now Is The Time To Invest In Real Estate (VNQ, SPG,PSA)

    Real estate assets have some of the strongest uptrends around. We'll take a look at three candidates poised for a move higher.
  9. Chart Advisor

    Stocks With More Upside Due to Bear Traps (TAP, SPY)

    A bear trap is a pattern that typically leads to at least a short-term rise in prices. Here are stocks exhibiting the pattern.
  10. Economics

    The Basics Of Business Forecasting

    Whether business forecasts pertain to finances, growth, or raw materials, it’s important to remember that a forecast is little more than an informed guess.
RELATED FAQS
  1. What is Fibonacci retracement, and where do the ratios that are used come from?

    Fibonacci retracement is a very popular tool among technical traders and is based on the key numbers identified by mathematician ... Read Full Answer >>
  2. What is finance?

    "Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >>
  3. What is after-hours trading? Am I able to trade at this time?

    After-hours trading (AHT) refers to the buying and selling of securities on major exchanges outside of specified regular ... Read Full Answer >>
  4. What is the difference between positive and normative economics?

    Positive economics is objective and fact based, while normative economics is subjective and value based. Positive economic ... Read Full Answer >>
  5. How many free credit reports can you get per year?

    Individuals with valid Social Security numbers are permitted to receive up to three credit reports every 12 months rather ... Read Full Answer >>
  6. How do financial advisors execute trades?

    Today, almost every investor invests through online brokerage accounts. Investors often believe that their trades are directly ... Read Full Answer >>
Hot Definitions
  1. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  2. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  3. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  4. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
  5. Dark Pool Liquidity

    The trading volume created by institutional orders that are unavailable to the public. The bulk of dark pool liquidity is ...
Trading Center