Stock Index

What is a Stock Index?

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:

• Price-weighted index;
• Modified price-weighted index;
• Market capitalization-weighted index;
• Market capitalization-weighted index adjusted for float; and
• Equally-weighted index.

For example:

• 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.

More Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

• Dow Divisor
• FTSE Indices
• Nikkei Index
• Index Funds
• See all wealth management resources