It’s a bit like university rankings
Many educational institutions are ranked using different parameters, but most rankings don’t actually rank all universities. Just as university rankings look at different countries and the way graduates perform by looking at individual degrees, stock market indexes measure performance of portions of the stock market. This is done by creating a hypothetical portfolio of investments which can be used as a representation of the portion of that financial market.
What is a stock market index?
We can say it’s a calculation of the stock market’s performance. It is calculated by looking at a selected portion of stock prices and taking their weighted average. Little high-school flashback: in a weighted average, larger amounts count more. Similarly, in a stock market index larger stocks weight much more in the calculation. A Stock Market Index it’s a good way for investors to get a feel of how a certain market is doing, since it works as a representative portfolio of certain investments. This also helps to compare the return of a certain investment. Indexes are also used to show the performance of a certain country’s stock market, or even the whole world.
Transparent & Investable
If the stock market index had a tagline, this would be it. With this, we mean that the way an index is created has to be very clear to everyone so that they can invest accordingly. There’s a few types of indexes which calculate performance differently. A price-weighted index gives more importance to companies which hold higher stock prices, thus skewing the final result towards these businesses’ performance. A market-capitalization-weighted index looks instead at the size of the companies, and averages the index accordingly. An equal-weight index averages all companies the same - no matter their size or stocks’ value.
Popular Stock Market Indexes
It's not like it’s a competition, but some stock market indexes are much better known than others. The three most renowned in the U.S. would be the S&P 500, the Dow Jones Industrial Average which is commonly known as “the Dow”, and the NASDAQ. These all use different methodologies to track performance of stocks. The S&P Index alone represents 80% of the U.S.’s stock market value. Because of this, it is a very good indicator of how the American economy is doing. Investors try to keep track of all of these, as they can then try (and we say try for a reason) to see trends and predict movements. Although this might sound like a fun game, our CEO that worked on Wall Street says it is not. Now, go play Monopoly instead.
Why will your future self thank you?
Because they are the trend-trackers of the stock market. One can get a sense of how well (or badly) a certain market is doing just by looking at a stock market index. These indices are also often used as a benchmark to see how a whole economy is doing, making them a whole lot of more relevant to other sectors outside of finance. Last but not least, the official plural of “index” is indices, but indexes is also accepted. Just so you know when you’ll be chatting with your friends about the topic.
- Some people call the stock market the “Dow” (from the Dow Jones Industrial Average Index, one of the oldest).
2. The S&P 500 Index is actually made up of 505 stocks.
3. The worst stock market crashes happened in October (and coincidentally this article was written in October, so let’s hope for the best).