What are stock indexes?
Technically stock indexes are a statistical average of a particular stock exchange or sector. I know, I know. For some, that sounds complicated. But here's the good news - you don’t have to know statistics to use and trade stock indexes.
The bottom line is that indexes are composed of stocks which have something in common – they are all part of the same exchange; they are part of the same industry; or they represent companies of a certain size or location. This is why one of the ways you can use a stock index is as a benchmark. If you want to know how a particular stock in an industry is doing, you can compare its performance against the statistical average of that industry. In other words, against the stock index.
There are many different stock indexes in the world. The most common in the United States are the Dow Jones Industrial Average, the NYSE Composite index, and the S&P 500 Composite Stock Price Index. Stock indexes give an overall perspective about the economic health of a particular industry or stock exchange.
There are several different ways to calculate indexes.
An index based solely on the price of stocks is called a 'price weighted index'. This type of index does not take into consideration the importance of any particular stock or the size of the company. An index which is 'market value weighted', on the other hand, takes into account the size of the companies. That way, price shifts of small companies have less influence than those of larger companies. Another type of index is the 'market-share weighted' index. This type of index is based on the number of shares rather than their total value.
As well as giving an overall grade to a particular economy, indexes can also be an investment instrument. Mutual funds based on indexes are known as 'passively managed mutual funds' and have been shown to consistently outperform managed funds. Mutual funds based on an index simply duplicate the holdings where the index is based on. Thus if the Dow Jones rises by 1% the fund based on the Dow Jones also rises by the same amount. This has the advantage of lower costs for research and transactions – savings that can be passed on to the investor who participates in these funds.
The Big Indexes
The Dow Jones Industrial Average is one of the best-known indexes in the United States. It follows the stock movements of 30 of the most influential companies in America including General Electric, Coca Cola and General Motors. It is a 'price-weighted average' index – thus giving more influence to more expensive stocks. Some analysts feel that the price-weighting does not give an accurate picture of stock market movements and that 30 companies are not enough to form an accurate assessment.
The S&P 500 Index is based on 500 United States corporations. These companies are carefully chosen to represent a broad slice of economic activity. It is second in influence after the Dow Jones and is felt to be an accurate predictor of the state of the United States economy.
Outside of the United States the most influential index is the FTSE 100 Index. This is based on 100 of the largest companies listed on the London Stock Exchange. It is an indicator of the British economy and is one of the biggest indexes in Europe. Other important non-US indexes are the CAC 40 from France and the Nikkei 225 from Japan.
As you can see, there are a variety of index funds. In fact, there are more than what we have listed. We have listed only some of the largest funds. There are more. For example, there are also: Russell 2000, Wilshire Large Growth, S&P 400 (501st to 900th largest U.S. stocks), and more.