Understanding Stock Indexes

If you have a stake in the stock markets, whether as an individual investor or retirement savings plan participant, you will want to know how well your stocks are doing. To do this, you need to compare investment performance against similar types of stocks. This is where an index is useful.

An index is defined as a statistical composite, or grouping of securities, which measures changes in the performance of similar classes of investments for purposes of comparison. The measurement is called an index because stock prices are indexed, or weighted, to reflect the number of shares outstanding. An index can demonstrate how a broad category of stocks respond to economic conditions over a given time period. Another commonly used term for an index is "benchmark".

Weighing An Index

The Dow Jones Industrial Average (the Dow) measures a small group of stocks-only thirty, but is viewed as a good barometer of what the economy in general is doing. There are different methods for weighing an index. Each stock in the Dow is weighted by price - making it a "price-weighted index". To calculate the price-weighted average of four stocks with values of $25, $35, $45, and $55 each, add the prices to get a total of $160, and divide by the number of stocks to get an average of $40.

Most major indexes use the "value-weighted method," also known as "market-cap weighted". To calculate the value-weighting for a given company, take the total market value for the company and divide that number by the total market value for all companies in the index.

Standard & Poor’s 500

The most commonly watched indexes, aside from the Dow, are value weighted. Another widely followed index, particularly by professional money managers and security market analysts, is the Standard & Poor’s 500 Stock Index ("S&P 500"). A measure of broad stock market activity, the S&P 500 is a composite of leading companies in leading industries, as opposed to the largest companies. It consists of 400 industrial, 20 transportation, 40 utility, and 40 financial companies of U.S. markets, which are primarily listed on the New York Stock Exchange.

NASDAQ

The NASDAQ composite is another well-known index. It was constructed by the National Association of Securities Dealers, and covers 4,500 stocks traded over-the-counter. While representing many small company stocks, the NASDAQ composite is heavily influenced by about 100 of its largest stocks.

What do these indexes mean to the average investor? Just as different groups of students are graded on how they are doing compared to their peers in school, different types of benchmarks measure stock performance. Anyone who follows a particular stock would need to look at the appropriate index to assess how well that stock is doing. In choosing a benchmark (there may be more than one) to assess a stock or mutual fund’s performance, an investment professional must first thoroughly understand the category in which the stock fits by looking at a number of elements: whether the stock is of a small, mid or large-cap company; the price/earnings ratio of the stock; the book-to-price ratio of the company, and risk factors to the industry and company, etc

As you can see, an index is essentially a measuring tool. Just as using as stopwatch would not work in assessing in a toddler’s progress in learning to walk, it is critical to use the appropriate index to evaluate a stock’s performance. This benchmarking can give you a much clearer, more precise determination of how your investments are doing.

Back to Top