If you've ever tried to explain how the stock market did on a particular day, you'll know that it's a deceptively tricky question to answer. There are hundreds of thousands of publicly traded companies around the world, and each of them might have experienced different gains and losses. To make it easier, we use "proxies" to define performance in a particular market. Most people are familiar with the well-known market proxy, the Standard & Poor's 500 Index.
Proxies Take the Temperature of the Market
A market proxy is a broad representation of the entire stock market. Analysts take a group of stocks in a particular class and combine their performances into an index — also called a proxy — for those stocks. The proxy acts a bit like a thermometer, measuring the health of the companies within the group. When business is booming, the proxy typically will go up. When the companies are performing poorly, the proxy index will fall.
How Proxies Are Classified
Proxies are classified in various ways: by region such as the U.S., Europe or Asia, by stock exchange, by business size or by industry such as energy, finance or electronics. The S&P 500 Index is essentially a bucket of the 500 largest stocks in the United States; Microsoft, Amazon, Apple, ExxonMobil and General Electric are all included in the S&P 500. Other main market proxies include the Dow-Jones Industrial Average, which represents one-fourth of the value of the U.S. stock market, and the Nasdaq Composite Index specific to the technology industry.
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Why We Use Proxies
A proxy is a quick way of checking how companies in a bucket are performing on a day-to-day basis. More specifically, investors use proxies as a benchmark to measure the performance of individual stocks against general trends in the marketplace. For example, if the S&P 500 is up by 15 percent in a year, but your stock portfolio is up by only 8 percent, then your investments are underperforming against market movement overall. When investing in stocks, it's important to find a proxy that reflects the sector of the market in which you are interested. Otherwise, the proxy will not give you a reliable benchmark of performance.
Investing in Market Proxies
Today, investors often choose to put their money into so-called passive funds, also known as index fund management. With passive investing, you're creating a portfolio that's intended to track the returns of a particular market proxy such as the S&P 500. Fund managers will choose stocks in the proxy bucket in the hopes of generating the same return as the proxy overall. Management fees tend to be pretty low with this type of investing since it's not especially proactive. The alternative is good old-fashioned stock picking, where investors use brokers to trade stocks in an attempt to outperform a specific proxy.