Stock Market Index Explained: What is a Stock Index & Their Types
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How Indices Work ?

What is a Stock Market Index?

An index measures a specific stock market or part of it continuously which helps investors assess current prices and performance versus previous ones. Indices are made up of the prices of several stocks and each has its own method of calculation.

 

Some indexes focus on a smaller part of the market. For example, there exist indices that focus only on the automotive sector in the USA while another index exists that tracks top dividend-paying stocks around the world. They also vary in size according to their coverage. The S&P 500is made up of the 500 largest corporations in the US while other indices may only contain a handful of stocks.

Weighting method of indices

There are different ways that stock indices are created and priced. The most common one is the Market capitalization calculation but price-weighted and equal-weighted also exist, among others.

Let’s look at some of the methods:

Market-cap weighted

This is calculated based on the market cap of each stock which is the number of outstanding stocks multiplied by the current price. In this case, larger companies will have more weight in the index, and changes in their price will affect the index much more than smaller companies and their price variations. For example, the S&P 500 (Figure 1) is a market-cap weighted index but there also exists an S&P that is equally weighted, meaning all companies within it carry the same weight.

Price weighted

This is calculated by using the stock’s price per share divided by the sum of all the prices within the index. Famous examples of this method including the Dow Jones Industrial Average and the Japanese Nikkei 225. Although not the most trustworthy method of gauging the stock market’s health, the correlation with more significant indices along with their popularity makes price-weighted indices a go-to index for day-to-day movements.

 

Figure 1 - Hourly S&P 500 Chart

Equal weighted

Indices with an equal weighting mean each stock is given a weight of 1/x where x represents the total number of stocks in the index. Again, this approach might distort the bigger picture, giving small-cap stocks more spotlight and reducing the significance of large-cap companies. It’s not a common calculation for indices but the Barron 400 Index is a well-known example of 400 stocks where each weighs 0.25%.

Volatility weighted

This is calculated by taking into consideration the volatility of a stock usually calculated as the standard deviation over 1 calendar year equating to around 252 trading days. The other calculation is a weekly standard deviation over 3 calendar years.

Major stock indices

The top 3 stock indices in the US and the world are:

 

Dow Jones: 30 of the largest and most significant US companies make up the Dow Jones index. It’s a price-weighted index and its holdings do not change very frequently.

S&P 500: The 500 biggest companies across different sectors, weighted by market cap. The S&P 500 is a good indicator of the performance of the stock market and the entire economy.

 

Nasdaq: Includes around 3000 companies that are part of the Nasdaq exchange with an emphasis on technology stocks.

 

Beyond those three, there exist thousands of indices spread across most countries of the world. Some indices may track the stock market of major trading centers such as Sydney or Tokyo while other indices might focus on a specific sector or industry. There’s nearly an index for every style or requirement and traders and investors will always be able to see how an idea or strategy might perform.

Other indices

Nasdaq 100: Focuses on the 100 biggest in the Nasdaq exchange and excludes financials. This index is geared towards tracking the performance of the tech sector.

 

Russell 2000: The Russell 2000 is made up of 2000 small-cap companies and shows how the smaller companies across the US