Exchanges & Indexes: Indexes

An index, in relation to investing, is a method of tracking the performance of a set of equities, based on a certain criteria (such as an industry, or company size, or equity type). The value of the index is determined by the prices of member stock, usually through an arithmetic mean. The three major indexes in the United States, all stock indexes, are the Dow Jones Industrial Average; the NASDAQ composite index; and the Standard & Poor's 500.

Membership in an index is generally determined by a weighting method (a calculation to determine a stock's value) or by coverage (securities in a specific geographic region, or industry, or membership in an exchange). The most common type of index uses market capitalization (the value of a stock multiplied by the number of shares outstanding) to determine the index's value, giving a higher percentage allocation to companies with the largest market caps. Larger companies, therefore, account for a greater portion of an index than smaller stocks. The weighted average market capitalization is determined by multiplying the current market price by the number of outstanding shares and then taking an average to determine the weighting.

Not all indexes use market capitalization as a weighting method. Price weighting and equal market cap weighting are two alternative methods. The Dow Jones Industrial Average uses the price weighting method, where the holdings are determined by a simple mathematical average of stock prices. In a price-weighted stock index, each company's stock is weighted by its price per share, and the index is an average of the share prices of all of the companies. Price-weighted indexes give greater weight to stocks with higher prices in terms of their contribution to the index value and changes in the index.

An equal-weighted index is a stock market index – comprised of a group of publicly traded companies. – that invests an equal amount of money in the stock of each company that makes up the index. Thus, the performance of each company's stock carries equal importance in determining the total value of the index. An equal-weighted index is beneficial to smaller companies by granting them equal footing with larger companies within the index.