What the Nasdaq actually is
People use Nasdaq, S&P 500 and Dow as though they all mean the market. They are three different things, and the Nasdaq is not even one thing.
On the same evening you can read that the market hit a record and that the market fell sharply, and both headlines can be entirely correct. They are simply talking about different markets. The three names quoted most often, the Dow, the S&P 500 and the Nasdaq, measure different things in different ways, and of the three the Nasdaq causes the most confusion. Part of the reason is that the word does not have one meaning at all.
Two things share the name
The Nasdaq is an exchange. It is a place where shares are bought and sold, and a company can choose to list there rather than at the New York Stock Exchange, in the same way a shop chooses which high street to open on. It began in 1971 as the first fully electronic market, with no trading floor and no shouting, which is why it attracted young technology companies that did not fit the older establishment.
The Nasdaq is also an index. When a newsreader says the Nasdaq rose two per cent, they almost always mean the Nasdaq Composite, which tracks the value of the thousands of companies listed on that exchange.
So the exchange is a venue and the index is a scoreboard, and both are called Nasdaq. Almost every muddle about this word comes from those two meanings being used interchangeably.
Why it swings harder
The practical question is why the Nasdaq so often moves more violently than the S&P 500, in both directions.
The answer is what is inside it. Because the exchange attracted technology companies from the beginning, the index is heavily weighted toward them, and technology businesses are valued mainly on profits expected years into the future rather than money arriving today.
That makes them unusually sensitive to interest rates. When borrowing costs rise, profits expected a decade from now are worth less in today's money, so the companies most dependent on distant earnings fall the hardest. When rates fall, the same effect runs in reverse and they rise the hardest. The S&P 500 contains those companies too, but it is diluted by banks, energy, healthcare and retail, so it feels the same news less sharply.
We set out that mechanism in Why interest rates move everything. The Nasdaq is what that article looks like in practice.
Three numbers, three methods
It is worth knowing how differently the three are built, because it explains why they disagree.
The Dow Jones Industrial Average holds just thirty large companies and weights them by share price, which is a genuinely odd method. A company with a high share price counts for more than one with a low share price, regardless of which business is larger. It survives because it is old and familiar rather than because it is well designed.
The S&P 500 holds around five hundred large American companies and weights them by size, so the biggest companies matter most. It is the closest of the three to a fair picture of the American market.
The Nasdaq Composite holds everything listed on the Nasdaq exchange, which is thousands of companies, also weighted by size. That means it includes a great many very small businesses alongside the giants, though the giants dominate the number.
The confusion this causes
Now the contradictory headlines make sense. A day when interest rate worries rise can push the Nasdaq down sharply while the Dow, stuffed with older industrial and healthcare names, finishes higher. Neither report is wrong. They are measuring different collections of companies using different methods.
This matters when you own an index fund, because "tracking the market" is not one choice. A Nasdaq fund is a concentrated bet on large technology companies, whatever it may feel like. That bet has been an excellent one for much of the past two decades, which is precisely what makes it easy to mistake for the market as a whole.
And then there are two Nasdaq indexes
One more distinction, because it trips up almost everybody who starts paying attention.
Alongside the Composite there is the Nasdaq-100, which holds the hundred largest companies on the exchange excluding financial firms. This is the one most people are actually invested in, because the enormously popular funds that track "the Nasdaq" usually track the hundred rather than the composite.
The two move together most days, since the giants dominate both. They are not the same thing though. The Composite includes thousands of small companies that the hundred ignores completely, so in a period when small businesses struggle and the giants do well, the two can drift meaningfully apart.
If you own a Nasdaq fund, it is worth knowing which of the two you actually hold. The name on the front of the fund is rarely specific about it, and the difference is a hundred companies against several thousand.
The takeaway
The Nasdaq is a venue and a scoreboard sharing a name, and the scoreboard leans heavily toward technology. When somebody tells you what the market did today, the useful question is which market, measured how, because the answer changes what the number means.
This article is educational and reflects the views of the Wealth Stratum community. It explains a general investing concept in plain terms and is not financial advice or a recommendation to buy or sell any security. Always do your own research. Photograph of the Nasdaq MarketSite by ajay_suresh, used under the Creative Commons Attribution 2.0 licence.