What Is a Stock Index?

By Markets Fool.com

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A stock index is used to describe the performance of the stock market, or a specific portion of it, and to compare returns of investments. Generally, an index uses a weighted average of stock prices, so larger companies count more in the calculation. The NASDAQ, S&P 500, and Dow Jones Industrial Average are examples of stock indexes.

Types of stock indexes

Some stock indexes simply represent the performance of a certain country or the entire world's stock market. For example, the S&P 500 is designed to show how the stocks of large U.S. companies are performing as a whole. The Wilshire 5000 index includes most of the U.S. stocks traded on the major exchanges, and is therefore intended to show the entire U.S. market's performance.

Other indexes are meant to track certain types of stocks -- growth stocks, value stocks, small-cap stocks, etc. The S&P 500 Value index, for instance, includes companies selected from the S&P 500 based on value-oriented criteria such as book value, earnings, and the price-to-sales ratio.

There are also stock indexes indented to track the performance of a certain sector. The S&P Financials Select Sector index includes banks, insurance companies, and REITs from the S&P 500.

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Price weighted vs. market-capitalization weighted

A price-weighted index like the Dow Jones Industrial Average assigns more weight to companies with higher stock prices. For example, in a hypothetical index made up of three stocks with share prices of $70, $20, and $10, the $70 stock would make up 70% of the total index, regardless of the relative size of the company.

A market-capitalization-weighted index, like the S&P 500, assigns weight based on each company's market capitalization. In the case of the S&P 500, large companies like Apple and Microsoft make up the bulk of the index, while smaller companies have a lesser contribution.

Finally, there is also such thing as an equal-weight index, where every company's performance has an equal contribution to the index. For example, the S&P 500 Equal Weight Index uses the same 500 companies as the S&P 500, but each company makes up exactly 0.2% of the index total.

Index funds: how you can invest in every stock in an index

An index fund is a mutual fund or ETF that allows investors to get exposure to an entire index without having to buy all of the individual components. For example, the Vanguard S&P 500 ETF actually owns all 500 stocks that make up the index, in approximately the same weights. In general, since index funds don't require active management -- just periodic rebalancing -- the fees involved are significantly lower than buying actively managed mutual funds or ETFs.

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