Investment Market Indexes
Indexes and averages track day-to-day changes in stock and mutual fund performance and can show trends in the financial markets. The best-known US indicators are Standard & Poor's 500 Index (S&P 500), the Dow Jones Industrial Average (DJIA), and the Russell 2000.
Both individual investors and institutional investors (like mutual fund companies and pension funds) use indexes and averages as benchmarks to evaluate performance. Indexes are also the basis for a variety of investment products, like index mutual funds, exchange traded funds (ETFs), and options contracts.
Measure for Measure
Each financial index or average is put together differently and tracks different securities, so each one provides different information about the markets. But two indexes tracking the same basic market, such as large-company stocks, will usually provide similar (though maybe not identical) results on any given day. On the other hand, an index tracking growth stocks will almost always be different from one that tracks value stocks.
Some indexes are very broad, tracking hundreds or even thousands of global securities. Others are narrowly focused on a specific sector of the US economy - utility companies, transportation companies, or manufacturing companies, for example.
Index or Average?
So why are some market benchmarks called indexes, when others are called averages?
A true average is an arithmetic mean. To find an average, add up the prices of all the securities and divide this by the total number of securities. For example, you could find the average price of 25 stocks by adding their individual prices and dividing by 25. The average changes as the prices of the securities change.
An index, in contrast, assigns a weight (or importance) to each security it tracks. That weight often corresponds to the size of the company relative to the index as a whole (more on that below). The index then divides the total market value of those securities by an index divisor, which is often different from the number of securities in the index. That value is in relation to a base value that the index provider chose. For instance, an index might have a base value of 100 as of March 28, 1985.
The best-known financial average, the DJIA, was originally an average but is now a hybrid. It's computed by adding the closing prices of its 30 stocks and then dividing by a number much smaller than 30. That number has been adjusted over the years to account for mergers and stock splits, as well as the changing roster of component stocks.
The movement, up or down, of both indexes and averages is shown both as a point change and a percentage change, though the percentage change is usually more useful.
Weighing the Outcome
Most stock indexes and averages are weighted, which means that some stocks in the index have higher value in the calculation than others.
Capitalization-weighted (cap-weighted) indexes are designed to reflect the economic impact of companies with the highest market capitalization. Market cap is calculated by multiplying the number of shares by their current market price. Most indexes are cap weighted, including the S&P 500 and the Nasdaq Composite Index.
Price-weighted indexes are more greatly affected by changes in the higher-priced stocks than by changes in the lower-priced stocks. The DJIA is a price-weighted index, as is Japan's Nikkei.
Equal-weighted indexes and averages give equal attention to the percentage changes in the price of all the stocks they measure. So, the percentage change in the value of each company in an index has the same impact on the value of the index. The S&P Equal Weight Index (S&P EWI), for example, tracks the same 500 stocks as the S&P 500, but gives them equal weight.
Weighing in on the Weightings
Cap weighting may create a more accurate measurement of how the economy is doing compared to other ways of weighting. For example, suppose the very largest companies (with their familiar brands) are turning in strong performances. It's reasonable to think that reflects robust financial markets even if some smaller companies in the same index are less robust or even flat.
On the other hand, market-cap weighting can also skew the real picture. When a just handful of large-cap or highly priced stocks behave differently from most stocks in the same index, such as the S&P 500, it isn't really telling the whole story. Similarly, the price-weighted DJIA may gain value based on a few high-flying stocks, even if the prices of most of the other 30 stocks aren't changing much at all.
It's also true that indexes computed as an arithmetic mean, or simple average, tend to report higher returns than indexes computed as a geometric mean. A geometric mean is a compounded (rather than averaged) return and accounts for the timing and severity of drops in the index.
Index mutual funds and most exchange-traded funds (ETFs) provide a way for you to invest in the performance of a particular market or section of that market, without buying all of the stocks or bonds in that market. To do that, the funds:
- License an index from an index provider
- Buy all or some of the securities in the index
- Make shares available to investors
The goal of an index-based fund is to replicate the performance of its underlying index. The closer its return is to the return of the index, the happier the fund and its investors are.
This approach is called passive investing because the securities held by the fund are determined by the same securities that make up the index. In an actively managed fund, in contrast, the fund manager or managers choose the securities for the fund's portfolio.