What is a Stock Market Index?
A stock market index is a relatively simple concept, and it allows you to see the big picture. It’s basically just a group of stocks that is given a numerical value that represents the value of all of the stocks in the index. Now, this isn’t a random group of stocks that you select. Instead it’s a number of stocks that are grouped together based on a common factor. For example, an index is typically made up of the stocks in a certain region, a certain exchange, a certain sector, etc.
A stock market index not the same thing as the stock market. These indices are part of the stock market, which includes all publicly traded securities. Some of the big indices include names that you’re probably familiar with such as the Dow Jones Industrial Average, the S&P 500, and the NASDAQ composite.
Not all indices are the same, and there are several types including broad based indices, market-value weighted indices, composite indices, and price weighted indices.
Broad Based Indices
These indices really show you the big picture, and they are striving to show the state of the whole market. This includes the big ones like the Dow Jones Industrial Average.
Market-Value Weighted Indices
These indices take the stock’s market capitalization into account, and they are also referred to as capitalization-weighted indices. Basically this type of index weights its numbers based off of company’s market capitalization. Market capitalization, or market cap, is the value of all of a company’s outstanding shares, which are shares that are held by investors. Treasury shares, which are held by the company, are not used to calculate market capitalization. If a big company has a big price change in terms of their shares, it will have a big effect on the index. Basically stocks with a higher market cap have more influence on the index than stocks with a smaller market cap. These indices include the S&P 500.
This is the combination of more than one index. It’s designed to give you a broader view of the market or a certain sector. Because they use a variety of indices, they are called composites. An example includes the NASDAQ composite.
Price Weighted Indices
Instead of basing the index value off of the stock’s market cap, this type of index bases it off of the stock’s price per share. So, the expensive stocks will have more of an influence on the index than the cheaper stocks. The Dow Jones Industrial Average is a price weighted index.
While there are a variety of indices, their main function is to show you how the market is behaving as a whole. Do you try to look at the big picture when you are investing in the stock market? Do you feel indices are useful?