What is a stock market index?

In the stock market world, you need a quick way to compare the movement of the market, up and down, from day to day, from month to month or from year to year. An index is just a benchmark or yardstick expressed as a single number that makes it possible to do such comparing.

How are indexes calculated?
Index calculation is a very interesting topic, because indexes are calculated in different ways. It is important for investors to understand the calculation methods involved for the indexes they refer to, because the calculation method has a profound impact on results. In simple terms, we want to know what is being measured.

Most stock indexes give more weight to larger companies. These indexes are referred to as capitalization-weighted (capitalization is simply the total market value of the outstanding shares of a company's stock). Since larger companies are weighted more heavily in these indexes, the index is not a valid indicator of the price of the average stock in the index. However, these indexes do give some indication of the price levels of the average investor's holdings, since theoretically there will be more investors in the larger companies. Examples of cap-weighted indexes include the Standard & Poor's 500 Index and the NASDAQ Composite Index.

Ironically, the most widely quoted index, the Dow Jones Industrial Average, relies on the most curious method of calculation. The Dow, as it is widely referred to, is price-weighted. Thus, higher-priced stocks receive more weight in this index than lower-priced stocks. The Dow includes 30 blue chip (high quality, large) stocks. The Dow is calculated by adding the trading prices of the component stocks, then using a divisor that is adjusted for stock dividends, splits and other factors. The average is quoted in points, not dollars.

What are some examples of widely used indexes?
At over 100 years, the Dow Jones Industrial Average is the oldest continuing stock market index. The Dow consists of 30 stocks, not all of which are industrial in nature. The sectors represented include financial, food, technology, retail, heavy equipment, oil, chemical, pharmaceutical, consumer goods and entertainment. The most striking similarity of the component stocks is their huge size; each has sales of over $7 billion per year. The Dow is the best-known market indicator in the world.

It is common knowledge that the calculation method for the Dow Jones Industrials is an archaic inheritance from the past that allows a stock movement by any size company to move the index by the same amount, and it is unlikely that anyone today would create a serious index based on such methods.

The Standard & Poor's 500, also referred to as the S&P 500, is also one of the most popular indexes. The S&P 500 is substantially broader than the Dow, including 500 stocks instead of just 30. As such, it is often used as a benchmark against which portfolio managers are evaluated. The S&P 500 Index is capitalization-weighted, meaning larger companies carry more clout in the index.

The NASDAQ Composite Index is increasingly popular, both because of the growing importance of NASDAQ Exchange-listed stocks, and that of technology stocks. The NASDAQ Composite Index includes all of the domestic and foreign companies listed on the NASDAQ Stock Market, almost 5,000 in all. Interestingly, the top few companies are so large compared to the rest of the NASDAQ that the top eight companies make up almost 32% of the entire index.

The S&P 500 and the NASDAQ each began at an arbitrary 100. The Dow hit 100 in 1906. The Dow index used a simple averaging method, while other indexes take the total market value of the stocks that the index represents, and then adjusts the index up or down for the net change in market value.

How is the Dow calculated?
Originally you just added up the prices of the 12 companies and divided by 12, very simple. In 1928, a divisor of 16.67 was used to adjust for mergers, takeovers, bankruptcies, stock splits, and company substitutions. Today, we add up the 30 stock prices and divide by .14452421. This means that for every $1 move in a Dow company's stock price, the average changes about $6.92.

If this seems like a good way to measure the performance of the stock market to the news services, it is because no one seems to want to declare how ridiculous the Dow Jones Industrial Average really is. Consider this:

The Dow measures the performance of only 30 companies out of thousands.
These companies are selected by the editors of a newspaper
The index is not market cap weighted as the S&P 500 is
If one of these companies isn't doing well, they substitute it with a hot new company, as when they kicked off Woolworth's to make way for McDonald's
All stocks are considered equally. If a $100 stock goes up $2 or just 2%, it moves the index exactly the same amount as a $20 stock going up the same $2 or 10%
The Dow does not include the effect of dividends, which over time can make a substantial difference.

How is the Standard and Poor’s 500 Calculated?
The S&P 500 Index, more formally known as the S&P 500 Composite Stock Price Index, is a European-style, capitalization-weighted index (shares outstanding multiplied by stock price) of 500 stocks that are traded on the New York Stock Exchange, American Stock Exchange and NASDAQ National Market. The advantage of "cap-weighting" is that each company's influence on index performance is directly proportional to its relative market value. It is this characteristic that makes the S&P 500 such a valuable tool for measuring the performance of actual portfolios.

The S&P 500 is thought of as representing the 500 largest American companies. Yes, they are primarily all large-cap corporations, but they are not necessarily the largest companies if you ranked them by sales, profits, assets, net worth, or their number of employees. The majority of these companies would certainly fall into one or more of these categories though. The S&P 500 represents about 80% of the total value of the American stock markets.

Created in 1928 with just 90 stocks, the S&P was increased to 500 in 1950. The index includes about 375 companies listed on the NYSE, a few from the AMEX, about 75 from the NASDAQ, and some foreign corporations whose operations are reflected in the U.S. economy.

How is the NASDAQ Calculated?
The NASDAQ Composite Index measures all NASDAQ domestic and non-U.S. based common stocks listed on The NASDAQ Stock Market. The Index is capitalization-weighted. This means that each company's security affects the Index in proportion to its market value. The market value, the last sale price multiplied by total shares outstanding, is calculated throughout the trading day, and is related to the total value of the Index.

Today the NASDAQ Composite includes over 5,000 companies, more than most other stock market indexes. Because it is so broad-based, the NASDAQ is one of the most widely followed and quoted major market indexes.