No doubt you’ve seen headlines reporting a particular stock index going up or down. but do you know what an index is and how understanding the nuts and bolts of a specific index can help you?
An index is simply a way of measuring and reporting the fluctuations of a group of securities or a representative segment of a market. An index is developed by a company that establishes specific criteria to determine which securities are included in the index based on factors such as the size or location of the company, or the liquidity of its shares. For example, the S&P 500 is an index comprised primarily of large-cap companies headquartered in the US. uu. which standard & poor’s considers itself to be leading representatives of a cross-section of industries.
Reading: How to read stock market index
The company that develops the index tracks the performance of its components and aggregates the data to produce a single number that represents the index as a whole. Virtually every asset class is tracked by at least one index, but due to the size and variety of the stock market, there are more stock indices than any other type. it is important to note that the performance of an unmanaged index is not indicative of the performance of any specific value. people cannot invest directly in an index.
comparing apples to oranges
Because indices cover a wide range of securities, it is important to know what segment of the market a particular index covers. for example, a composite index tracks a specific stock market. The Nasdaq Composite Index includes all stocks listed on the Nasdaq Market. by contrast, sector indices track values in a specific industry.
even indices that include the same values may not operate in exactly the same way. In general, indices tend to be price or market capitalization weighted. If an index is price-weighted, such as the Dow Jones Industrial Average, each stock’s impact on the overall average is proportional to its price compared to other stocks in the index. with a price-weighted index, the higher-priced stocks would have the biggest impact on the average. For example, a 1 percentage point drop in the price of a stock that was selling at $80 per share would have more impact on the overall performance of the index than a 1 percentage point drop in the price of a stock that was selling at $40 per share. action.
If an index is market capitalization or market value weighted, such as the Nasdaq Composite Index or the S&P 500 Composite Index, the index average is adjusted to account for the relative size of each company (its market cap) to reflect its importance to the index. Stocks with a larger market capitalization have a greater influence on the performance of the index than stocks with a smaller market capitalization. For example, if the shares of a company with a market capitalization of $10 billion fall by 1 percentage point, the index’s performance will be affected more than a 1 percentage point drop in the share price of a company with a market capitalization of 1,000 million dollars.
Although an index adheres to a set of guidelines for the selection of the stocks it includes, the company that oversees the index generally reviews the stock selection periodically and may make changes from time to time. for example, some indices may rebalance if an individual security grows so large that it dominates the index. others have a cap on how much of the index can be devoted to a particular sector or industry, and can be rebalanced if the ratio drifts.
it is worth looking at the indices
Stock indices can provide valuable information for the individual investor. If reviewed regularly, an index can provide information that can help you stay on top of how the stock market in general, or a particular segment, is doing. however, understanding the differences between the indices and how each works will help you make better use of the information they provide. All investments involve risk, including possible loss of principal, and there is no guarantee that any investment strategy will be successful.