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You’ve no doubt heard the term “stock index” before. Whenever financial news is talked about, stock indices are a big part of the discussion. But, what does the term mean, and what do you need to know about them? If you’ve wanted to know more about stock indices, read on.
What is a Stock Index?
A stock index, also known as a stock market index, is a tool used by investors and market analysts to measure the stock market’s performance. A stock index is not an actual stock in itself. Instead, it is a number derived by averaging the performance of several stocks. As these stocks — and the average index — is tracked throughout the course of weeks, months and even years, an investor can get a good idea of how the overall market is performing.
What Are some of the Major Indexes?
There are many, many stock indices that financial investors keep their eyes on. In the US, the biggest three indices are the Dow Jones Industrial Average, the Nasdaq Composite, and the S&P 500. Other areas of the world also have their own major indices, such as the Nikkei 225 in Japan, the FTSE 250 in the UK and the Hang Seng Index in Hong Kong. Indices can track the performance of stock in a smaller region, such as an individual country, to a larger regions. The MSCI World, for example, is a global index that tracks the performance of many major stocks world-wide.
What, Exactly, Do Indices Track?
As stated above, stock indices track the overall performance — losses and gains — of a number of selected stocks. Even more than this, though, is the fact that indices usually are set up to keep an eye on a certain section of the economy. The Dow Jones, for example, is made up of 30 of the largest companies in the US, and represents a cross-section of industries, from McDonalds to Walmart to Goldman Sachs. The NASDAQ, on the other hand, is an index that is made primarily of stocks from tech-related companies. Other indices can shine a light on how other sectors of the economy are doing. There are even indices established that are based on company ethics. The Dow Jones Sustainability Index is one such index that highlights companies that adhere to certain ethical standards.
Price Weighted vs Market Capitalization Weighted Index
Stock market indexes can be either price weighted or capitalization weighted.
A price weighted index just uses the stock price of the index component stocks to create an index. A $1 move in any of the stocks in the index will have a small and similar impact on the overall index value. Dow Jones 30 Index is a popular price weighted index of blue chip stocks.
A market capitalization weighted index assigns greater weight to stocks with larger market values. As a result, price changes in the more prominent stocks in the index have a greater impact on the index value. Many of the other popular indices such as S&P 500 and Nasdaq are market capitalization weighted.
Growth Vs Value Index
You will also find specialized indices that track popular stocks by investment styles. Typically most major indices are further broken down into Growth and Value style based sub-indexes. For example, Russell 2000 is a popular index that tracks the top 2000 or so small cap stocks. Russell 2000 Growth tracks the growth stocks from this list (based on EPS growth and other “growth” indicators, while Russell 2000 Value tracks the value stocks from this list (based on P/E, P/B and other value focused indicators).
Size based Index
Other indexes track the performance of the asset classes based by market capitalization. For example, S&P 500 tracks the large cap stocks in the US while S&P Midcap 400 tracks mid cap stocks and S&P Smallcap 600 tracks the small cap universe of stocks.
Sector and Industry Indexes
Stock indices exist that track various sectors of the economy. For example, there are indexes that track transportation stocks, shipping stocks, biotech stocks, commodity stocks, etc.
Many of these indexes exist so that index linked investment products such as mutual funds and ETFs can be based upon them. This allows investors a diversified exposure to specific sectors of the economy. Other more popular indexes serve as a benchmark for investment managers to track their fund performance against.
Now that you know a little more about stock indices, you should be able to watch them over the course of time and note how they move. Generally speaking, numbers moving upward indicates a healthy trend in the overall economy, while a downward motion can be a harbinger of trouble in the future. In reality, though, the market fluctuates constantly, so day-to-day movement does not, by itself, indicate much.