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An Introduction to U.S. Stock Market Indexes
Stock market indexes around the world are powerful indicators for global and country-specific economies. In the United States the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite are the three most broadly followed indexes by both the media and investors. In addition to these three indexes there are approximately 5,000 others that make up the U.S. equity market.
With so many indexes, the U.S. market has a wide range of methodologies and categorizations that can serve a broad range of purposes. The media most often reports on the direction of the top three indexes regularly throughout the day with key news items serving as contributors and detractors. Investment managers use indexes as benchmarks for performance reporting. Meanwhile, investors of all types use indexes as performance proxies and allocation guides. Indexes also form the basis for passive index investing often done primarily through exchange-traded funds that track indexes specifically.
Overall, an understanding of how market indexes are constructed and utilized can help to add meaning and clarity for a wide variety of investing avenues. Below we elaborate on the three most followed U.S. indexes, the Wilshire 5000 which includes all the stocks across the entire U.S. stock market, and a roundup of some of the other most notable indexes.
- There are approximately 5,000 U.S. indexes.
- The three most widely followed indexes in the U.S. are the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite.
- The Wilshire 5000 includes all the stocks from the U.S. stock market.
- Indexes can be constructed in a wide variety of ways but they are commonly identified generally by capitalization and sector segregation.
The S&P 500
The Standard & Poor’s 500 Index (known commonly as the S&P 500) is an index with 500 of the top companies in the U.S. Stocks are chosen for the index primarily by capitalization but the constituent committee also considers other factors including liquidity, public float, sector classification, financial viability, and trading history. The S&P 500 Index represents approximately 80% of the total value of the U.S. stock market. In general, the S&P 500 Index gives a good indication of movement in the U.S. market as a whole.
Indexes are usually market weighted or price weighted. The S&P 500 Index is a market weighted index (also referred to as capitalization weighted). Therefore, every stock in the index is represented in proportion to its total market capitalization. In other words, if the total market value of all 500 companies in the S&P 500 drops by 10%, the value of the index also drops by 10%.
The Dow Jones Industrial Average
The Dow Jones Industrial Average (DJIA) is one of the oldest, most well-known, and most frequently used indexes in the world. It includes the stocks of 30 of the largest and most influential companies in the United States. The DJIA is a price-weighted index. It was originally computed by totaling the per-share price of the stocks of each company in the index and dividing this sum by the number of companies. Unfortunately, the index is no longer this simple to calculate. Over the years, stock splits, spin-offs, and other events have resulted in changes in the divisor (a numerical value computed by Dow Jones used to calculate the level of the DJIA) making it a very small number (less than 0.2).
The DJIA represents about a quarter of the value of the entire U.S. stock market, but a percent change in the Dow should not be interpreted as a definite indication that the entire market has dropped by the same percent. This is because of the Dow’s price-weighted function. The basic problem is that a $1 change in the price of a $120 stock in the index will have a greater effect on the DJIA than a $1 change in the price of a $20 stock, although the higher-priced stock may have changed by only 0.8% and the other by 5%.
A change in the Dow represents changes in investors’ expectations of the earnings and risks of the large companies included in the index. Because the general attitude toward large-cap stocks often differs from the attitude toward small-cap stocks, international stocks, or technology stocks, the Dow should not be used to represent sentiment in other areas of the marketplace. In general, the Dow is known for its listing of the U.S. markets best blue-chip companies with regularly consistent dividends. Therefore, while not necessarily a representation of the broad market, it can be a representation of the blue-chip, dividend-value market.
The Nasdaq Composite Index
Most investors know that the Nasdaq is the exchange on which technology stocks are traded. The Nasdaq Composite Index is a market-capitalization-weighted index of all the stocks traded on the Nasdaq stock exchange. This index includes some companies that are not based in the United States.
Known for being heavily tech weighted, this index includes several subsectors across the tech market including software, biotech, semiconductors, and more. Although this index is known for its large portion of technology stocks, it does include some securities from other industries as well. Investors will also find securities from a variety of sectors as well, including financials, industrials, insurance, and transportation stocks, among others. The Nasdaq Composite includes large and small firms, but unlike the Dow and the S&P 500, it also includes many speculative companies with small market capitalizations. Consequently, its movement generally indicates the performance of the technology industry as well as investors’ attitudes toward more speculative stocks.
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The Wilshire 5000
The Wilshire 5000 is sometimes called the “total stock market index” or “total market index” because it includes all of the publicly traded companies with headquarters in the United States that have readily available price data. Finalized in 1974, this index represents the entire U.S. stock market and its movement aggregately. Although it is a very comprehensive measure of the entire U.S. market, the Wilshire 5000 is referred to less often than the more popular S&P 500 Index.
A Roundup of Other U.S. Indexes
Generally, there are a few ways to look at indexes broadly. Capitalization is often key, with indexes falling into either large-, mid-, or small-cap buckets. The S&P 500 and Dow Jones Industrial Average are two of the top large-cap indexes, but others include the S&P 100, the Dow Jones U.S. Large-Cap Total Stock Market Index, the MSCI USA Large-Cap Index, and the Russell 1000. Notable mid-cap indexes include the S&P Mid-Cap 400, the Russell Midcap, and the Wilshire US Mid-Cap Index. In small-caps, the Russell 2000 is an index of the 2,000 smallest stocks from the Russell 3000. Other popular small-cap indexes include the S&P 600, the Dow Jones Small-Cap Growth Total Stock Market Index, and the Dow Jones Small-Cap Value Total Stock Market Index.
Investors also commonly look to sectors with Standard & Poor’s leading in this realm of the market. Standard & Poor’s manages: the S&P Communication Services Select Sector, S&P Consumer Discretionary Select Sector, S&P Consumer Staples Select Sector, S&P Energy Select Sector, S&P Financial Select Sector, S&P Health Care Select Sector, S&P Industrial Select Sector, S&P Materials Select Sector, S&P Real Estate Select Sector, S&P Technology Select Sector, and the S&P Utilities Select Sector. These indexes represent the S&P 500’s comprehensive sector segregations.
The growth of smart beta index investing has also helped to increase the number of indexes in the market. Smart beta indexes are passive indexes that are built using certain characteristic or fundamental screens that help to improve the quality of index constitution. Advisors Asset Management (AAM) has three smart beta index funds in the market that largely encompass the entire global market for dividend and value investing. AAM’s smart beta index funds include the AAM S&P 500 High Dividend Value ETF (SPDV), the AAM S&P Developed Markets High Dividend Value ETF (DMDV), and the AAM S&P Emerging Markets High Dividend Value ETF (EEMD).
What Is a Market Index?
A market index is a hypothetical portfolio of investment holdings which represents a segment of the financial market. The calculation of the index value comes from the prices of the underlying holdings. Some indices have values based on market-cap weighting, revenue-weighting, float-weighting, and fundamental-weighting. Weighting is a method of adjusting the individual impact of items in an index.
Investors follow different market indexes to gauge market movements. The three most popular stock indexes for tracking the performance of the U.S. market are the Dow Jones, S&P 500 and Nasdaq Composite. In the bond market, Bloomberg Barclays is a leading provider of market indexes with the U.S. Aggregate Bond Market Index serving as one of the most popular proxies for U.S. bonds. Investors cannot invest directly in an index, so these portfolios are used broadly as benchmarks or for developing index funds.
Understanding Market Indexes
Market indices measure the value of a portfolio of holdings with specific market characteristics. Each index has its own methodology which is calculated and maintained by the index provider. Index methodologies will typically be weighted by either price or market cap. A wide variety of investors use market indices for following the financial markets and managing their investment portfolios. Indexes are deeply entrenched in the investment management business with funds using them as benchmarks for performance comparisons and managers using them as the basis for creating investable index funds.
- Market indexes provide a broad representative portfolio of investment holdings.
- Methodologies for constructing individual indexes vary but nearly all calculations are based on weighted average mathematics.
- Indexes are used as benchmarks to gauge the movement and performance of market segments.
- Investors use indexes as a basis for portfolio or passive index investing.
Each individual index has its own method for calculating the index’s value. Weighted average mathematics is primarily the basis for index calculations as values are derived from a weighted average calculation of the value of the total portfolio. As such, price-weighted indexes will be more greatly impacted by changes in holdings with the highest price, market cap weighted indexes will be most greatly impacted by changes in the largest stocks, and so on depending on the weighting characteristics.
Indexes as Benchmarks
As a hypothetical portfolio of holdings, indexes act as benchmark comparisons for a variety of purposes across the financial markets. As mentioned, the Dow Jones Industrial Average, S&P 500 and Nasdaq Composite are three popular U.S. indices. These three indexes include the 30 largest stocks in the U.S. by market cap, the 500 largest stocks and all of the stocks on the Nasdaq exchange, respectively. Since they include some of the most significant U.S. stocks, these benchmarks can be a good representation of the overall U.S. stock market.
Other indexes have more specific characteristics that create a more narrowly targeted market focus. Indexes can represent micro-sectors or maturity in the case of fixed income. Indexes can also be created to represent a geographic segment of the market such as those that track the emerging markets or stocks in the United Kingdom and Europe, such as the FTSE 100.
Investors may choose to build a portfolio with diversified exposure to several indexes or individual holdings from a variety of indexes. They may also use benchmark values and performance to follow investments by segment. Some investors will allocate their investment portfolios based on the returns or expected returns of certain segments. Further, a specific index may act as a benchmark for a portfolio or a mutual fund.
Institutional fund managers use benchmarks as a proxy for a fund’s individual performance. Each fund has a benchmark discussed in its prospectus and provided in its performance reporting which offers transparency to investors. Fund benchmarks can also be used to evaluate the compensation and performance of fund managers.
July 3, 1884
The date that the world’s first stock index, the Dow Jones Transportation Index, was published by Charles Dow. The index was made up of 11 transportation stocks, including nine railway companies.
Institutional fund managers also use indexes as a basis for creating index funds. Individual investors cannot invest in an index without buying each of the individual holdings which is generally too expensive from a trading perspective. Therefore, index funds are offered as a low-cost way for investors to invest in a comprehensive index portfolio, gaining exposure to a specific market segment of their choosing. Index funds use an index replication strategy which buys and holds all of the constituents in an index. Some management and trading costs are still included in the fund’s expense ratio but the costs are much lower than fees for an actively managed fund.
Real World Examples
Some of the market’s leading indexes include:
- S&P 500
- Dow Jones Industrial Average
- Nasdaq Composite
- S&P 100
- Russell 1000
- S&P 400
- Russell Mid-Cap
- Russell 2000
- S&P 600
- U.S. Aggregate Bond Market
- Global Aggregate Bond Market
Investors often choose to use index investing over individual stock holdings in a diversified portfolio. Investing in a portfolio of indexes can be a good way to optimize returns while balancing risk. For example, an investor seeking to build a balanced portfolio of U.S. stocks and bonds could choose to invest 50% of their funds in an S&P 500 ETF and 50% in a U.S. Aggregate Bond Index ETF.
Investors may also choose to use market index funds to invest in emerging growth sectors. Some popular emerging growth indexes and corresponding ETFs include the following:
What Is a Stock Market Index?
Learn how you can track the overall performance of a group of stocks over time.
What is an index?
A stock market index is a measure of a stock market, or a smaller subset of the market, that helps investors compare current price levels with past prices to calculate market performance. Investors use the calculated values of stock market indexes as an indicator of the current value of their component stocks, and they can determine returns over time by comparing current and past index levels.
Stock market indexes come in many different sizes. Some indexes have only a handful of stocks that determine their value, while others take thousands of stocks into account. You can’t invest directly in a stock market index, but by investing in index funds that allow investors to track the performance of those indexes, you can make money and profit when those indexes go up . These index funds can be structured as mutual funds or exchange-traded funds (ETFs).
Why should I follow stock market indexes?
Stock market indexes can be useful to follow for a few key reasons:
- Tracking the most-followed stock market indexes can give you a general sense of the health of the overall stock market.
- Tracking lesser-known indexes can help you see how a particular segment of the market is performing compared to the market as a whole.
- If you don’t want to invest in individual stocks but rather simply want to match the performance of the overall market, then a cost-effective way to earn solid returns over time is by investing in index funds that track the stock market indexes you’re most interested in.
Stock market indexes make it easier to know how the market is performing without having to follow the ups and downs of every individual stock. They also open up simple investment opportunities that even novice investors can use to participate in the long-term success of the stock market.
How should I read a stock market index?
Reading an index correctly requires that you look at how the index value changes over time. New stock market indexes always begin with a certain fixed value based on the stock prices on its starting date. Thereafter, future index values measure rising and falling prices for those component stocks.
Image source: Getty Images.
Not all stock market indexes use the same starting value, however, so just measuring index changes by using points can be misleading. For instance, if one index rises 250 points in a day while another rises just 10 points, it might seem as though the first index performed far better. However, if the first index started the day at 25,000 while the second index was at 250, then you can see that in percentage terms, the gains for the second index were far greater. A higher percentage gain means a bigger profit for you if you invest in funds that track the index, so it’s better to focus on percentages than on point movements.
Moreover, even the most popular stock market indexes don’t generally measure the performance of the entire market. Knowing which stocks are in an index can tell you which parts of the stock market are contributing to that index’s performance and can explain why other indexes might not be performing the same way.
What are the major stock market indexes?
Most investors track the performance of three key stock market indexes:
- The Dow Jones Industrial Average (DJINDICES:^DJI) is the oldest stock market index in the U.S., dating back to the 19th century. It tracks 30 stocks that encompass a wide array of different market sectors, excluding only transportation and utility companies. The manager of the Dow tends to keep its 30 component stocks unchanged for years at a time, replacing companies only when necessary to keep up the index’s reputation of including only stocks of top-quality companies.
- The S&P 500 (SNPINDEX:^GSPC) is a broader index that includes about 500 large-company stocks. Its component stocks get replaced much more frequently, as the index attempts to include a representative mix of companies that reflect the overall U.S. economy.
- The Nasdaq Composite (NASDAQINDEX:^IXIC) is an index of stocks that trade on the Nasdaq Stock Market. Investors often use the Nasdaq as a gauge of the performance of the technology sector, because many of the largest and most influential components of the Nasdaq are tech stocks.
Beyond these well-known indexes, however, there are hundreds more stock market indexes. You can find indexes that reflect the performance of stocks in a certain country or that do business in a given sector of the economy. Some indexes separate large, mid-sized, and small companies into different categories. Others use investing strategies like growth, value, or dividend investing to select component stocks. Pretty much any type of stock you might be interested in, there’s an index for that. The rise of index mutual funds and ETFs has led to a proliferation of indexes to help fund managers use passive investing strategies to minimize costs and let investors tailor their portfolio exposure as precisely as they like.
How are indexes weighted?
Each component stock in an index has a weighting assigned to it. Stocks with higher weightings have more influence on the index’s movements than those with lower weightings, and there are three different ways that indexes typically assign weightings to their stocks:
- Price-weighted indexes give more weight to companies with higher stock prices. For example, in a hypothetical index made up of three stocks with share prices of $70, $20, and $10, the $70 stock would make up 70% of the total index, regardless of the relative size of the company. The Dow Jones Industrials is the most important example of a price-weighted index.
- Market-capitalization-weighted indexes give more weight to companies with higher market capitalizations. Both the S&P 500 and the Nasdaq Composite are market-cap weighted, and large companies like Apple and Microsoft have much greater weightings than the smaller companies that make up the indexes.
- Equal-weight indexes simply assign the same weighting to each stock, regardless of price, market capitalization, or any other factor.
There are some other stock market indexes that use proprietary methods to come up with weightings. For example, some indexes assign weightings based on the dividends that a stock pays out. For the most part, though, market-cap-weighted indexes are most prevalent, as they’re often the easiest for index funds to track.
Learn What Market Indexes Say About Investing
If you read or listen to the financial media, you might get the impression that the Dow Jones Industrial Average, usually referred to as the Dow, represents the pulse of the market. Other stock indexes like the S&P 500 or the Nasdaq Composite also get mentioned more or less often, depending on their numbers.
These and other reported indexes can give you a good amount of information and insight to use in making more informed investing decisions.
Explaining Index Numbers
First, take a look at what an index number represents. Although there are different ways to calculate index numbers, the numbers always represent a change from an original or base value. The base value represents the weighted-average stock price of all the stocks that make up the index.
The index number has much less importance or meaning than its percent change over time. This movement up or down gives you an idea of how the index is performing. Is the Dow up or down? The index gets calculated on an ongoing basis each day during the stock market’s open hours, to give investors a sense of direction for the market the index represents.
Be aware, though, that most stock indexes, even those quoted as representing the total stock market, only reflect a portion of the actual market. This happens because each index typically holds stocks from certain sectors or categories of the market.
Reading the Indexes
Keep these factors in mind when analyzing and interpreting changes in a given index:
- Indexes don’t represent the total market. No matter what happens with the big three indexes, stay focused on your stocks or targets for evaluation. Pick any day that all three indexes are down, and you will still see some stocks setting new highs that same day.
- Indexes react to actual trades. If you listen to some of the financial news commentators, you might think the indexes move on emotion. Investors may want to trade on the expectation of good or bad news, but index movements require actual trades, not just investor feelings.
- Focusing on day by day, hour by hour, minute by minute clicks of an index makes for a good way to eat up valuable time.
- Indexes provide a better historical perspective, rather than a forecasting vehicle. They can be especially helpful when viewed over a long historical period when researching trends.
The Informational Pros and Cons
Indexes provide useful information including:
- Even with their limitations, indexes show trends and changes in investing patterns.
- They can give snapshots of market activity, even if they don’t tell the whole story.
- Indexes provide a yardstick for comparison over time.
Indexes, by design, have some seemingly major flaws that make them suspect to some investors as representative of any truly useful information.
- People decide which stocks to include and which to remove and people make mistakes. Sometimes stocks get included that shouldn’t be and stocks are removed that shouldn’t be, for various reasons. In addition, this process repeats year after year, making it difficult to look back and compare the S&P 500 of 1995 with the S&P 500 of 2004.
- By weighting the indexes (except for the Dow) by size, disproportion representation goes to large or giant companies. If one of them has a bad day, it can throw off the whole index.
The Major Indexes
The following summarizes the most popular indexes and the market sectors they capture:
The Dow Jones Industrial Average (DJIA) is the oldest and most widely known index. It is also the most widely quoted index and often, whether right or wrong, considered the market barometer.
Originally, it was a simple average of the stock prices in the index, but thanks to stock splits, spin-offs, and other transactions, the index now requires a more sophisticated price-averaging calculation. You can find more information at the Dow Jones Indexes site. The Dow currently holds 30 stocks. However, these stocks represent some of the largest and most influential companies in the U.S.
The Dow is the only major index that is price-weighted, which means if a stock’s price changes by $1, it has the same effect on the index regardless of the percent change for the stock. In other words, a $1 change for a $30 stock has the same effect as a $1 change for a $60 stock.
The calculation of the Dow takes into account numerous stock splits over the years. By adjusting the math, it is possible to keep a historically viable index meaningful.
The Dow stocks represent about one-quarter of the value of the total market, so in that sense, it is a telling factor and big changes can indicate investor confidence in stocks, however, it does not represent investor sentiment regarding any small or mid-size companies.
The S&P 500 is the most frequently used index by financial professionals as a representative of the market. It includes 500 of the most widely traded stocks and leans towards larger companies.
It covers about 70 percent of the market’s total value, so in those terms, it much more closely represents the true market than the Dow. The S&P 500 is a market capitalization or market-cap-weighted index, as are almost all of the other major indexes.
Weighting by market cap gives more importance to larger companies, so changes in Microsoft stock will have a greater impact on the index price than almost any other stock in the index. Even though the S&P 500 is weighted toward larger companies, because it includes so many companies, it provides a more accurate gauge of the broader market than the Dow.
Even though the financial media may emphasize the Dow, you can get a clearer picture of the market by focusing your attention on the S&P 500.
The Nasdaq Stock Market Composite includes all the stocks listed on the Nasdaq market, which totals more than 5,000 companies. Although broad in coverage, the Nasdaq is heavily weighted to technology stocks. It’s a market cap-weighted index and stocks of very large companies like Microsoft and some of the other big technology companies influence the index.
Their influence and the population of small, speculative companies in the Nasdaq make the index more volatile than either the Dow or the S&P 500. The Nasdaq wasn’t designed to represent the overall market, however, it does provide good insight into the mindset changes of technology investors.
A number of other indexes exist that measure larger or smaller sections of the market. Additionally, mutual fund investors can find a number of funds that track almost any index they want.
The major three indexes above, however, will serve most investors well. Should you want to look at other indexes for comparison, make sure you understand how the index is weighted (most, if not all, will be weighted based on market cap) and how the stocks held by the index were selected.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.
What Is a Stock Index?
A stock index is a compilation of stocks constructed in such a manner to replicate a particular market, sector, commodity, currency, bond, or anything else an investor might want to track. Indexes can be broad or narrow. For example, the NASDAQ Composite tracks thousands of common stocks and similar securities that are traded on the Nasdaq stock exchange. The more specified Nasdaq 100 Index (NDX) is an index that tracks the largest 100 non-financial companies listed on the NASDAQ Composite.
Keep reading for a further explanation of how indexes track markets, as well as ways that investors can use them to build a portfolio.
How an Index Works
The underlying holdings in an index are commonly referred to as the index’s “basket of stocks.” For example, the Dow Jones Industrial Average Index (DJIA) includes 30 of the largest U.S. companies.
These indexes act as guidelines for investors trying to replicate a particular asset, market, or region. An investor who wants to add exposure to large-cap U.S. stocks can use the Dow as a guide for which stocks to pick.
Similarly, the Philadelphia Gold and Silver Index (XAU) consists of companies that mine gold and other precious metals. If you buy the stocks in the index, you will gain balanced exposure to the gold mining sector without having to buy shares in every single gold mining company in the world. The shares in the XAU are representative of the gold mining industry as a whole.
Alternatives to Replicating Indexes in Your Portfolio
While you can individually buy all the stocks in an index, there’s an easier way to add index exposure.
Mutual funds and exchange-traded funds (ETFs) track indexes. These products essentially lower the barriers to entry to buying these indexes. Rather than saving up the money needed to buy one share of every stock listed on an index, an investor can obtain the same diversification by buying shares in a mutual fund or ETF that tracks that index.
Fees are the primary drawback to mutual funds and ETFs. A fund manager ensures that the underlying stocks replicate the index being tracked, so investors pay fees to compensate the manager.
While ETFs, like any investment, come with certain disadvantages, they’ve become incredibly popular. In 2020, ETF assets under management topped $4 trillion. Many investors find that the advantages of ETFs outweigh the drawbacks. For example, ETFs enjoy certain tax advantages over the mutual funds that track the same index.
Index-weighting refers to the method of how the shares in an index basket are allocated. In other words, an index’s weighting is how the index is designed. For example, a price-weighted index buys shares in proportion to the cost of those shares. A stock worth $20 might have one share included in the index, whereas a stock worth $5 would have four shares included.
The most popular type of weighting is based on market capitalization. The shares of each stock in a cap-weighted index are based on the total market value of the company’s outstanding shares. Put simply, this means the index includes more shares of companies that are worth more, and fewer shares of smaller companies.
Other possible methods of weighting include revenue-weighted indexes, fundamentally-weighted indexes, and float-adjusted indexes.
Advantages of Buying an Index
Indexes are a nice way to gain exposure to certain markets or sectors without having to place thousands of orders. It’s cheaper and simpler than doing the research and placing the orders to replicate a sector on your own.
Depending on the sector being tracked by the index, buying indexes may be the only option for an average investor looking to expose themselves to certain markets. For example, not everyone has the space to store barrels of oil, herds of cattle, or bags of wheat. Instead, these investors can buy the appropriate commodity index that tracks the market they want to buy into.
Disadvantages of Buying an Index
While an index is designed to emulate a certain market, that doesn’t mean it’s 100% accurate. Just because you buy a foreign market index in a certain region, that doesn’t mean your basket will perfectly reflect the economy of that region. Many factors can alter the course of an economy, and sometimes it’s difficult for an index to accurately account for all of those factors.
Not all indexes are liquid. It may be difficult to trade in and out of certain positions, depending on the index you track. Then again, the same thing can be said for certain securities, as well.
In fact, all the downsides that come with other forms of investing also apply to index investing. That includes issues related to order type—market orders will execute quickly but they won’t guarantee a price, while limit orders control the price at the cost of timeliness.
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