If you’re an investor, you probably own a small portion of stocks within your portfolio and regularly track individual performance. This is a norm in stock market trading, where you monitor how other stocks perform and possibly gauge where to channel your next investment.
However, stock performance is not always the same across your investment portfolio. The performance of stocks in one small portfolio does not always paint a true picture of the overall market.
For example, it doesn’t capture market sentiment—one of the many pieces of information an investor needs. Stock indices can be helpful because they provide a measurable number representing the overall market.
This could further extend to a selected group of stocks or a sector and, in many cases, serve as a benchmark for investment comparisons. In this blog post, learn everything you need to know about stock indices, including how they are calculated.
What are Stock Indices?
Stock indices refer to a selected group of stocks or shares representing an economy, sector, or exchange. It shows how these stocks are performing, giving investors an idea of the overall market trend.
A stock index can be a single number calculated from the prices of various stocks trading on the market. You can think of it as a scorecard that tracks how well a group of companies is doing overall.
For example:
- S&P 500 has 500 of the largest U.S. companies.
- Dow Jones Industrial Average (DJIA) focuses on 30 large, established companies.
- NASDAQ Composite mainly tracks technology companies.
Investors use stock indices to:
- Track market performance.
- Compare the performance of individual stocks to the broader market.
- Serve as benchmarks for mutual funds and exchange-traded funds (ETFs).
How Stock Indices are Calculated?
Most stock market indices are calculated by the market capitalization of their component companies. The methodology gives greater weighting to larger-cap companies, meaning their performance consequently affects an index’s value more than that of lower-cap companies.
Here is more on how the stock indices are calculated:
1. Price-Weighted Index
A price-weighted index gives greater weight to stocks with higher share prices. The higher the price of a stock, the greater its impact on this type of index.
How it works:
- Add together the share prices of all the companies in the index.
- Divide the total by a fixed number called the “divisor.”
The divisor is used to accommodate events such as stock splits or changes to the roster of companies in the index.
Example:
Suppose you have an index containing three companies:
- Company A: $100 per share
- Company B: $50/Share
- Company C: $25 per share
The sum of these costs is $ 175. If the divisor is 5, then the index value is: 175 / 5 = 35
A classic example of price-weighted indices is the Dow Jones Industrial Average.
2. Market Capitalization-Weighted Index
This is perhaps the most common method of calculating stock indices. In this method, a company’s higher market capitalization automatically influences its index composition.
How it works:
To calculate market capitalization, you multiply a company’s stock price by the number of its remaining shares.
- Calculate the market cap of each company in the index.
- Add all the market caps together.
- Divide by the total market cap for the weighted average.
Example:
Let’s consider three companies:
- Company A: $100 per share 1,000,000 shares = $100 million market cap
- Company B : $50/share × 2 million shares = $100 m market capitalization
- Company C: $25 a share issued 4 million shares = $100 million market capitalization
If the market cap of all the companies amounts to $300 million, then the contribution of each company to the index is the same.
Examples of cap-weighted indices are the S&P 500 and NASDAQ Composite
3. Equal-Weighted Index
In an equally weighted index, every company has the same weight regardless of its size or stock price.
How it works:
The performance of each stock is considered to be of equal importance and is calculated by taking the average return performances of all the stocks that make it up.
Example:
If three firms have returns of 5%, 10%, and 15%, the return of the index would be:
5%+10% + 15%= ×3 = 10%
Equally weighted indices, by contrast, yield a more neutral picture but involve periodic rebalancing if their weights are to remain uniform.
Factors That Influence Stock Index Values
There are many reasons why stock indices might rise or fall. These include:
- Stock price changes: If the index is price-weighted, a change in the price of one stock will have a higher impact on the index value.
- Market capitalization fluctuations: If the index is market cap-weighted, stocks with higher market caps going up or down will have a higher weight in calculating an index.
- Economic events: News such as interest rate changes, inflation releases, or global events can impact stock prices and, in turn, indices.
How to Use Stock Indices as an Investor?
Understanding how indices fluctuate can help you make smarter investment decisions. Here are a few tips:
- Performance monitoring: Follow stock indices to get a sense of where the market is going
- Evaluate the performance: Use indices to compare the performance of your investments.
- Compare investments: Use indices to evaluate potential investments.
Final Thoughts
Stock indices serve as important guides for investors, providing knowledge about the stock market and how to proceed. Whether price-weighted, market-cap-weighted, or equal-weighted, each index is calculated differently and serves its own purpose.
If you’re already an investor or plan to invest in the stock market, knowing how stock indices are calculated can help you interpret market trends and make informed investment choices.