June 12: What is a Stock Index?

by David Jenyns on June 12, 2007

In the fast paced ever-changing world of today’s stock market you need a quick way to analyze and graph the movement from day to day, month to month or year to year. Stock indexes such as the Dow Jones Industrial Average and Standard and Poor’s 500 give you a tool to do just that.

But what exactly is a stock market index? A stock market index is a listing of a group of stocks, and a number to go with them. The number that goes with them is used to track trends in the market, going up or down when the market does. In general the stocks have something in common, such as trading on the same exchange, or belonging to the same industry. The Indexes can be classified in a wide variety of ways. The most widely quoted Index in the world, the Dow Jones Industrial Average, is a broad based index designed to reflect the stock market as a whole and give an idea of investor sentiment on the state of the economy.

How are indexes Calculated?

Different Indexes are calculated in different ways and it is important for stock investors and traders to understand how the index they are using is calculated because the calculation method has a large impact on results. You need to know what is being measured and how. The Dow Jones Industrial Average, for instance, was originally just that. In the beginning, when there were no calculators or computers, and calculations needed to be done quickly and by hand, there were 12 stocks in the Dow Jones Index, which were counted up and then divided by 12. The results were expressed as points. Now, with computers the norm, the index is calculated differently.

Most stock indexes such as Standard & Poor’s 500 Index and the NASDAQ Composite Index are weighted and give more weight to larger companies. These are capitalization -weighted indexes (Capitalization is the total market value of any outstanding shares of a companies stock.) These indexes are not valid indicators of the price of the average stock in the index. Since there should be more investors in the larger companies they do give us an idea of price levels in an average investor’s holdings.

The Dow Jones Industrial Average, however is NOT capitalization-weighted. It is price weighted, giving more importance to higher priced stock then lower priced ones. The Dow Jones Industrial Average now includes 30 stocks. It is calculated by adding together the price of those stocks and then using a divisor. The Dow average is quoted in points and not dollars.

Types of indexes.

The most widely quoted indexes are the broad based indexes, which attempt to represent the movement of an entire stock market. They normally include the largest companies on the nation’s largest stock exchange. Standard and Poor’s 500 (S+P 500 index) and the Japanese Nikkei 225, as well as the Dow Jones industrial average, are examples of this type of index.

More specialized sorts of indexes are indexes like Morgan Stanley’s Biotech, which consists of 36 American biotech firms, or NEMA’s EIS (National Electrical Manufacturer’s Association’s Electroindustry Stock Index) which tracks Electroindustry stocks.

Indexes that track companies of a certain size or a certain type of management are also fairly common.

Indexes may also include stock on more than one exchange…

Socially Responsible Indexes or Sri indexes

Another specialized index type are those for Socially Responsible Investing indices that include only those companies satisfying ecological or other social criteria. Often called SRI or Socially Responsible Indexes, SRI indexes allow investors to watch stocks according to their beliefs and performance on Social issues, and may exclude companies such as arms or tobacco companies. They include The Calvert Group, Domini, the Dow Jones Sustainability Index, and the FTSE4Good indices

With so many ways of grouping stock it is often difficult to choose which index, if any, are the ones you should follow. Deciding what you want to track and how you want to track it is important. Make sure you pick the indexes that are right for your investment strategy, and easily understandable for you.

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