QuickMBA / Finance / Stock Indexes
Stock indexes are useful for benchmarking portfolios, for generalizing the experience of all investors, and for determining the market return used in the Capital Asset Pricing Model (CAPM).
A hypothetical portfolio encompassing all possible securities would be too broad to measure, so proxies such as stock indexes have been developed to serve as indicators of the overall market's performance. In addition, specialized indexes have been developed to measure the performance of more specific parts of the market, such as small companies.
It is important to realize that a stock price index by itself does not represent an average return to shareholders. By definition, a stock price index considers only the prices of the underlying stocks and not the dividends paid. Dividends can account for a large percentage of the total investment return.
One characteristic that varies among stock indexes is how the stocks comprising the index are weighted in the average. Even if no explicit weighting is applied when calculating an average, there may be an implicit one. While a one dollar price change in one stock in a simple stock price index will have the same effect as a one dollar change in any other stock, a given percentage increase of a higher price stock influences the index more than a corresponding percentage increase of a lower price stock. For example, a 1% change in a $100 stock will change the index more than a 1% change in a $10 stock. For this reason, indexes that are based on the simple summation of stock prices are referred to as price-weighted.
In a price-weighted index, a change in the stock price of the largest company in the index would influence the average no more than an equal change in the stock price of the smallest company in the index. However, the larger company's performance will have a greater impact on the economy. To consider the size of a company, a market capitalization weighted index (or value-weighted index) can be used, in which a company's impact on the index is proportional to the size of the company. In value-weighting, in effect the market capitalization of the stocks influence the index, not the prices. For this reason, there is no need to adjust for stock splits.
Some indexes do not weight for market capitalization, but do adjust for price differences to remove the implicit price weighting. This unweighted method tracks the performance of an index in which equal dollar amounts are invested in the underlying stocks. Some consider an unweighted index to be a good indicator of the market's performance from the perspective of the investor who places an equal amount of money in each stock in his or her portfolio, regardless of its market capitalization. However, if every investor placed an equal amount of money in each investment, relatively few investors would own small-cap stocks, so an unweighted index would not reflect the portfolio performance of the average investor when all investors are considered.
There are hundreds of indexes that are designed to measure the broad market or specific parts of it. Here are some of the more commonly-used indexes, listed in alphabetical order.
Dow Jones Industrial Average
The Dow Jones Industrial Average is a price-weighted index of industrial stocks and is the most widely quoted stock index.
In the early 1880's, there was no broad market measure - investors focused on the prices of individual stocks. On July 3rd, 1884 Dow Jones & Co. first published an index of 11 companies in the Customer's Afternoon Letter, which later became the Wall Street Journal. At that time, there were 9 railroad stocks and 2 industrial stocks in the index. In 1884, the railroads were the largest and most stable companies. The stocks of industrial companies were considered speculative investments. In 1896, Charles Dow introduced an index for industrial stocks and the original Dow average became a railroad stock index. More companies were added to the industrial index until 1928, when the number was increased to 30.
The Dow Jones Industrial Average uses a divisor to adjust for events that result in no change in a company's value but that would otherwise influence the index. One such event is a stock split; another is the replacement of one company in the index by another. While this adustment does not result in a change in the index value when a stock splits, because the index is price-weighted the newly split stock will have a lower price and therefore less influence on the index.
Dow Jones Transportation Average
The Dow Jones Transportation Average is a price-weighted index. It originated from the index of 9 railroad stocks and 2 industrial stocks that Dow Jones & Co. introduced in 1884. In 1896 when the original index became the Dow Jones Railroad Average the industrial stocks were removed from it. Later, the Railroad Average was renamed to the Transportation Average. In addition to railroads, today the average includes other transportation stocks such as airlines and trucking companies.
Dow Jones Utility Average
The Dow Jones Utility Average is a price-weighted index of 15 utility stocks, especially electric utilities and gas utilities. It was created in 1929 with 18 stocks, was increased to 20 stocks six months later, then reduced to 15 stocks in 1938.
Nasdaq Composite Index
The Nasdaq Composite Index is a market capitalization weighted index of more than 5000 stocks. Comprising all Nasdaq-listed common stocks, it is the most commonly used index for tracking the Nasdaq.
The Russell 2000 is a market capitalization weighted index. It was created in 1984 by the Frank Russell Company. The Russell universe of stocks covers 3000 companies, and the Russell 2000 represents the smallest two-thirds of those companies. As such, it is a small-cap index.
The S&P 100 is a market capitalization weighted index of large-cap companies. This index also is known by its ticker symbol, OEX. It comprises 100 large blue-chip companies across a wide range of industries.
The S&P 500 is a market cap weighted index of large-cap companies from a variety of industries. It includes industrial, utility, transportation, and financial stocks. The S&P 500 is widely used as a benchmark by institutional investors.
Value Line Composite Index
The Value Line Composite Index is a broad, unweighted index of approximately 1700 companies covered in the Value Line Investment Survey.
The Wilshire 5000 is a market capitalization weighted index. It was created by Wilshire Associates in 1974. It is the broadest index, including virtually every actively traded U.S. stock.
Isaacman, Max, How To Be An Index Investor
Covers the following topics:
- Overview and Trading of Exchange Index Shares
- Individual and Professional Strategies for Using Exchange Shares
- Behavioral Finance
- The Electronic Index Investor and Trader
- The Select Sector SPDRs
- SPY and MDY
QuickMBA / Finance / Stock Index Primer
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