Stock market indexes get computed and quoted every day. You've no doubt heard the daily performance of the "Dow Jones Industrial Average" reported during the evening news broadcast. Indexes are used to gauge how well the stock market is doing and also how well the economy is performing.
But how do you pick an appropriate index to use as a benchmark for the entire domestic economy? The "Dow" has only 30 industrial companies. Is it a good indicator?
There are dozens of separate market indexes and at least three different methods for computing daily market performance. Here is a general description of the different computation or "weighting" methods and examples of indexes that use each method: 1) price-weighted, 2) value-weighted, and 3) equally-weighted. It is important to have a basic understanding of each method because each has its own bias, which can make an ordinary trading day seem extraordinary.
Price-Weighted - Each company's percentage of the total index is their stock price divided by the total of all the companies' stock prices. This method, therefore, overweighs high price stocks in the portfolio. An example of a price-weighted index is the Dow Jones Industrial Average (DJIA)
Value-Weighted - Each company's percentage of the total index is based upon its market capitalization, which is the stock price times the number of shares outstanding. This method does not overweight or underweight any stock's prices or returns, but has a bias toward larger market capitalization. Examples of value-weighted indexes are the Standard & Poor's (S&P) 500, Nasdaq Composite, and Russell 2000.
Equally-Weighted - Each company's percentage of the total index is equal. This method implies equal dollar amounts of each stock are bought and, therefore, overweighs larger percent changes. An example of an equally-weighted index is the Value Line Composite Average.
Indexes will make adjustments for stock splits, changes in composition, and such. However, most indexes do not reflect the impact of cash dividends. The S&P 500, a value-weighted index whose companies make up 70% of the market capitalization of all U.S. stocks, is the index that most professional advisors watch very closely in formulating opinions about economic and stock market performance. Hundreds of stock index funds are available that seek to mirror the performance of the S&P 500 and other market indexes.