WHAT IS AN INDEX?

An index is “a statistical measure of the changes in a portfolio of stocks representing a portion of the overall market.”

It would be too difficult to track every single security trading in the country. To get around this, we take a smaller sample of the market that is representative of the whole. Thus, just as pollsters use political surveys to gauge the sentiment of the population, investors use indexes to track the performance of the stock market. Ideally, a change in the price of an index would represent an exactly proportional change in the stocks included in the index.

Charles Dow created the first, and consequently, most widely known index back in May of 1896. At that time, the Dow index contained 12 of the largest public companies in the United States. Today, the Dow Jones Industrial Average (DJIA) contains 30 of the largest and most influential companies in the US.

Before the digital age, calculating the price of a stock market index had to be kept as simple as possible. The original DJIA was calculated by adding up the prices of the 12 companies and then dividing that number by 12. These calculations made the index truly nothing more than an average, but it served its purpose.

Today, the DJIA uses a slightly different methodology, called price-based weighting. In this system, the weight of each security is the stock’s price relative to the sum of all the stock prices. The problem with price-based weighting is that a stock split changes the weight of a company in the index, even though there is no fundamental change in the business. For this reason, not too many indexes are weighted on price.

Most indexes weight companies based on market capitalization. If a company’s market cap is $1,000,000 and the value of all stocks in the index is $100,000,000, then the company would be worth 1% of the index. These types of systems are made possible by computers–most are calculated by the second and so are very accurate reflections of the market.

Most indices therefore are based on market capitalization, the most popular of these are designed and managed by the S&P and Dow Jones. It’s important to note that an index is nothing more than a list of stocks – anybody can create one. This was especially true during the dot-com market, when practically every publication created an index representing a section of new economy stocks. What sets the big indexes apart from the small ones is the reputation of the company that puts out the index, and the number of products (futures, options, exchange traded funds, mutual funds, etc.).

Traditionally every major western country has a stock index that investors use to gauge the health of that country’s economy. These days, as the European Union becomes a more unified market place, indices representing the economic area are now the most popular. However, country based indices are still widely used in Europe and of course in the US.