How do stock market indexes work - By: Jim Knight

If there’s one thing that captures the mood of a nation, it’s the stock market index. When the Dow Jones Industrial Average ("Dow Jones") or Standard & Poor’s 500 ("S&P 500") falls, the collective mood of the nation goes down; when it rises, national mood rises with it.

What makes stock market indexes so important?

Stock market indexes are used to measure the performance of the stock markets, and in this way are indicators of the economic health of the nation. They can be used as benchmarks for comparing the performances of individual stocks or even portfolios, both of individuals and entities like mutual funds.

How do stock market indexes work?

Stock market indexes consider some select stocks in the markets when coming up with a consolidated value, and the basis of this selection can be size, industry, etc. There are two major ways in which this value is calculated – price weighing and value weighing. This gives rise to the two main types of indexes – price weighted index and value weighted index, of which Dow Jones and the S&P 500 are prime examples, respectively.

In an index, each of the constituent stocks contributes a percentage of the total value. This is its weight in the index. In a price-weighted index, the price of the stock is the only determinant of this weight. Therefore, a highly-priced stock of a small company can have a larger weight than a lower-priced stock of a large company. In such a situation, price movement of even a single stock will heavily influence the value of the index even though the dollar shift is less significant.

For a value weighted index, it is the market value of all the stock or its market capitalization that determines its weight. Thus, a relatively small shift in the stock price of a large company will heavily influence the value of the index.

While traditional value weighted indexes have considered all outstanding shares when determining market value, some of the recent ones consider only the floating shares, that is, the shares in the hands of public investors as opposed to company officers, directors, or controlling-interest investors. The reason behind this distinction is that only floating shares are accessible for trading, and such an index may be additionally representative from the a certain investor’s point of view.

Which are the popular stock market indexes?

The most popular stock market indexes in the US are:

* Dow Jones – Price weighted index of 30 stocks which are the largest representatives from different industries in the New York Stock Exchange and NASDAQ exchange.

* S&P 500 – Value weighted index of the 500 stocks with the highest market capitalizations in the New York Stock Exchange and NASDAQ exchange.

* NASDAQ Composite – Value weighted index of more than 5000 stocks on the NASDAQ exchange. Since non-US stocks are also listed in NASDAQ, this index is not exclusively a US stock market index.

These are only a few of the hundreds of indexes available worldwide, tens of them in the US itself. Some of the famous global ones are Hong Kong’s Hang Seng, Tokyo’s Nikkei, London’s FTSE 100 and Mumbai’s Sensex.

About the Author

The alerian mlp etf (NYSE: AMLP) delivers exposure to the Alerian MLP Infrastructure Index (AMZI), giving investors a means of tracking the overall performance of the United States energy infrastructure Master Limited Partnership asset class.

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