Stock Market Indices
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Indices are the price of a group of stocks which are quoted to give investors an overall view of how the market is moving. They can also be used by the financial media as a barometer of how the economy is performing overall. While the performance of a particular index may not reflect that of an individual stock you are interested in, it does give you an indication of the sentiment of other investors in the market. The composition and weighting of each index varies which can make it difficult to compare when investing in different markets so it is important to understand how the index is constructed.
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The most widely used index in the USA is the Dow Jones Industrial Average [official site]. This index is made up of thirty very large companies which are weighted by price and then adjusted by a current average divisor. The divisor is used so that when the component companies are changed the index retains continuity; however this is a rare occurrence with only forty eight changes in over a hundred years of the index.
The Dow Jones Industrial Average is only a small snapshot of the market and an investor may be
interested in far more than thirty companies. A wider index for the US market is the Standard and Poor’s 500 [official site] which includes five hundred companies listed on the New York Stock Exchange. The index is weighted by market capitalization which means that a small company cannot distort the price of the index. For the more specialized investor there are indices covering individual sectors and the Russell 2000 Index [official site] which covers smaller companies.
Other markets have their own range of indices and for the global investor the most widely followed are the FTSE 100 [official site] for the London Stock Exchange and the Nikkei 225 [official site] for the Tokyo Stock Exchange. The FTSE 100 is weighted by market capitalization but the Nikkei 225 is not. Other indices around the world have even more differences so it is essential to study the composition of the index before using it as a tool for investing.
Some investors use an index as a benchmark to judge how their portfolio is performing. While this is a widespread practice, the index performance does not include any costs for transactions or holding shares and is calculated using mid prices. A portfolio made up of the same shares as the index would not give identical performance. The vast majority of indices do not factor in dividends paid and if these are reinvested each year the actual portfolio value would be increased.
Other markets have their own range of indices and for the global investor the most widely followed are the FTSE 100 [official site] for the London Stock Exchange and the Nikkei 225 [official site] for the Tokyo Stock Exchange. The FTSE 100 is weighted by market capitalization but the Nikkei 225 is not. Other indices around the world have even more differences so it is essential to study the composition of the index before using it as a tool for investing.
Some investors use an index as a benchmark to judge how their portfolio is performing. While this is a widespread practice, the index performance does not include any costs for transactions or holding shares and is calculated using mid prices. A portfolio made up of the same shares as the index would not give identical performance. The vast majority of indices do not factor in dividends paid and if these are reinvested each year the actual portfolio value would be increased.