Lesson 7: Stock Market Indices

Lesson 7: Stock Market Indices

Stock Chart Going Up
Lines Going Up = Good in Finance

In the last lesson I mentioned how my father would always mention to me how “the market was up”.  Knowing now that there thousands of companies traded in the equity markets you may wonder what my father meant by “the market”. Was it that on that day he saw more green, upward arrows on MSNBC than red, downward arrows? Was it that on that particular day his stocks were doing well and he wasn’t paying attention to the other stocks? He was most likely looking at stock market indices such as the DJIA, S&P 500, or Russell 2000. These indices (or indexes) are commonly used to describe the health of the overall stock market and as a result are closely monitored day in and day out.

Key Points

  • An index is an imaginary portfolio of securities that represent a particular market. (Ex. Stock market indices track the stock market).
  • Indices are primarily constructed through a price-weighted or value-weighted method.
  • The Dow Jones Industrial Average (DIJA) is one of the weaker indices when reporting the performance of the stock market.
  • The S&P500 and other value-weighted indices are indices that report a more comprehensive performance of the stock market.

What Is A Stock Market Index?

A stock market index is an imaginary portfolio of stocks that serves the role of representing the entire stock market.  In other words by looking at the performance of an index one should be able to discern the growth or decline in the stock market.  There are a number of different indices that are reported including the Dow Jones Industrial Average (also called the “DOW” or “DJIA), the Standard & Poor’s 500 (S&P 500), and the Russell 2000 are some of the most well-known indices.  Why are there more than one index if they all serve the same purpose of measuring the stock market? As we discussed in the last lesson the stock market is a complicated system and there are a variety of ways to measure it. Thus different indexes have emerged utilizing different methodologies to answer the question “How is the stock market performing?”

Constructing An Index: Price-Weighted vs. Value-Weighed

There are two primary ways that indices are constructed price-weighted and value-weighted.

  • Price-Weighted Index: In a price weighted index the stock price is what influences the index.  To use an example let’s assume there is an index comprised of two stocks: 1. ReallyBig Company 2. Microtiny Company furthermore let’s assume that ReallyBig has a stock price of $100 per share and Microtiny Company has a stock price of $1. If the index is constructed this way a change in ReallyBig Company’s stock price affects the index ninety nines (99x) greater than a change in Microtiny’s stock price. This index is 99% comprised of ReallyBig Company’s stock and 1% of Microtiny’s company. In summary in a price-weighted index it is the stock price that influences the index. The DIJA is a price-weighted index.
  • Value-Weighted Index: In a value weighted index the individual stocks are weighted according to their market capitalization. (stock price x shares outstanding) Let’s return to our two companies of ReallyBig and Microtiny.  Let’s say at a given time that Really Big has only 500 shares outstanding giving ReallyBig a market capitalization of $50,000. Meanwhile Microtiny has 50,000 shares outstanding giving Microtiny a market capitalization of $50,000 as well. Thus with a value-weighted index ReallyBig and Microtiny have equal influence on the index even though their stock prices are very different.  The S&P500 and Russell 2000 are value-weighted indices.

Really Big’s Market Capitalization =Stock price x Shares Outstanding = $100 x 500 shares = $50,000

Microtiny’s Market Capitalization = $1 x 50,000 shares = $50,000

Why No One Should Pay Attention to the DIJA

The Dow Jones Industrial Average (DJIA) is a price-weighted index comprised of 30 of the largest and most influential companies in the United States. (A complete list of the companies in the index is here) One of the key things to notice about the weights of the index are quite concentrated. About 60% of the weight of the index lies in the top ten components alone.  To illustrate the inherent problem with this consider the following situation: On a certain day the vast majority of the stock market is actually up (most stock prices have increased), but the stock prices of the top ten companies of the DJIA for some reason have decreased over the course of the day.  Based on this although the market may be up, the DIJA would indicate that the market is actually is actually experiencing decline. Thus the DIJA has the flaw of employing a non-diverse methodology for trying to track a large and diverse problem.  Why is this index still so greatly followed? It is one of the relics of time that has been around for so many years that many investors and financiers just

What to Pay Attention to? Value-Weighted Indices

So what do we turn to for a more accurate picture? Simple, turn to more inclusive, diverse value weighted indices. The S&P500 for example contains not 30, but 500 of the largest companies’ stocks (A complete list including the weight in the index can be found here).  By containing approximately 70% of the total value of the U.S. stock market the S&P500 is a much more accurate and comprehensive indicator of the stock market versus the small glimpse that the DJIA reports. There are other value-weighted indices such as the Russell 2000 and Willshire 5000 that both grant a more comprehensive view than the DJIA.

When someone says that “the market is up” you can almost certainly conclude that on that day either the DJIA or the S&P500 is up that particular day, and if the DJIA is down while the S&P500 is up you now have the tools to explain why the market is still in fact up.

 

Definitions

  1. Stock market index: An imaginary portfolio of securities that represent a particular market.
  2. Price-weighted index: An index in which stock price is the main determinant of component weight.
  3. Value-weighted index: An index in which market capitalization is the main determinant of component weight (also called market capitalization index).
  4. Market capitalization: The total equity value of a company measured by a company’s stock price times its common shares outstanding.

 

Further Reading

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