A collection of stocks that are used to assess the performance of an economy, market, or specific sector
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A stock index, also called a share index or stock market index, consists of constituent stocks used to provide an indication of an economy, market, or sector. A stock index is commonly used by investors as a benchmark to gauge the performance of their portfolio. Examples of stock indexes include the Dow Jones Industrial Average (DJIA), the Nikkei Stock Average, the S&P 500, the Nasdaq Composite, and the Wilshire 5000.
Stock Index Composition
A stock index is comprised of constituent stocks that, when pooled together, provides an indication of something. For example:
The Dow Jones Industrial Average comprises 30 of the largest and most influential companies; and
The S&P 500 consists of the top 500 U.S. stocks by capitalization.
The Dow Jones Industrial Average and S&P 500 are used in mass media to provide a broad indication of economic performance in the United States.
Stock Index Weighting
Stock indexes can follow different weighting methods, such as a:
Market capitalization-weighted index adjusted for float; and
The Dow Jones Industrial Average is a price-weighted index; and
The S&P 500 is a market capitalization-weighted index.
The weighting method used carries implications on the performance of an index.
The S&P 500
The S&P 500 chart is taken from Google and provided below:
Recall that the S&P 500 is used in mass media to provide a broad indication of economic performance in the United States. From the S&P 500, we can discern economic events in each major downtrend of the index, including:
The Tech Boom in 2000; and
The Global Financial Crisis in 2008.
As one can see, the S&P 500, consisting of the top 500 U.S. stocks by capitalization, provides a pretty good representation of major economic events.
Example – An Industry Indicator
Colin recently decided to create two stock indexes.
Index 1 – Automobile:
The first stock index, provided below, consists of five automobile stocks that he believes provides a good representation of the automobile industry in the United States:
Using a capitalization-weighted index, the value of the stock index above is $10,000 + $15,000 + $20,000 + $50,000 + $300,000 = $395,000.
Index 2 –Telecommunications
The second one, provided below, consists of five telecom stocks that he believes provides a good representation of the telecommunications industry in the United States:
Using a capitalization-weighted index, the value of the stock index above is $50,000 + $1,500 + $7,000 + $46,250 + $243,750 = $348,500.
Impact of Steel Tariffs
The next day, the US president imposes a 50% steel import tariff. The market index constructed by Colin is now as follows:
Index 1 – Automobile
Using a capitalization-weighted index, the index’s value is $9,000 + $13,500 + $18,000 + $45,000 + $270,000 = $355,500 – which is a decrease from $395,000 before the implementation of the steel tariffs. Colin is able to see that the steel import tariff imposed by the US leader negatively affected the automobile industry.
Index 2 – Telecommunications
Using a capitalization-weighted index, the index’s value is $50,000 + $1,500 + $7,000 + $46,250 + $243,750 = $348,500 – which is identical to $348,500 before the implementation of the steel tariffs. Colin is able to see that the steel import tariff imposed by the US leader did not affect the telecommunication industry.
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