Written by Norman Isaac Mwambazi

What is a market index?

A stock market index tracks the upward and downward movement of a chosen group of stocks, bonds, or other assets. …

A stock market index tracks the upward and downward movement of a chosen group of stocks, bonds, or other assets. Investors, shareholders, and analysts watch the performance of a market index to see how healthy the stock market is, and this acts as a guide for financial firms in setting up index funds and exchange-traded funds (ETFs). For those that already have a portfolio, a market index helps them track the performance of their investments.

These investments are often grouped by sector like tech stocks, industry and manufacturing, and cryptocurrency. However, some indexes cover the broad stock market, and examples include the S&P 500 that acts as a benchmark for the stock market performance, the Dow Jones Industrial Average (DJIA), and the Nasdaq Composite Index.

There is no set size for market indexes so that an index can have as little as 10 stocks or as many as 5000 stocks. The Dow Jones Industrial Average, for example, carries only 30 stocks of prominent companies listed on stock exchanges; the S&P 500 index contains 500 stocks, the FTSE 100 in London is made up of 100 companies, while the CRSP index has more than 3,700. The most important aspect of each of these market indexes is that they contain a sample size large enough to represent the overall performance of the market segment they aim to represent.

How stock market indexes are constructed

No one formula is followed to create a market index as each uses its proprietary formula to determine which stocks or other assets to include in the index. The formula considers share price, market capitalization, earnings performance, and market sector, among others, to pick which companies to include. A company could be added to an index, and when its performance fails to meet the prerequisites of that market index after some time or for a period set of time, it can be dropped from that index.

Indexes that measure the performance of broad swathes of the market may only include companies that rank highly in terms of market capitalization or the total value of all of their outstanding shares. Alternatively, they may be selected by an expert committee or simply represent all of the shares that trade on a particular stock exchange.

After selecting which stocks to include in the index, the index manager then has to determine their index weighting. This is how the selected stocks will be represented in the index. Depending on market capitalization and share value, stocks included in a market index can either impact the index’s performance equally or differently. It is worth noting that just because a company has a large market capitalization does not mean that its shares will be the most expensive. For example, Apple Inc. (ticker: AAPL) is the largest company by market capitalization, but there are hundreds of companies whose shares are more expensive than Apple’s.

Common index weighting models

There are three common index weighting methods in the stock market: market-cap-weighted, equal-weighted, and price-weighted.

Market-Cap Weighted

The index represents stocks with larger market capitalizations, which means that large companies have a bigger impact on the index’s performance.

Equal Weighted

The index treats all components the same, which means that all companies in the index have the same amount of impact on the index’s performance, whether large or small.

Price Weighted

The index grants each company a different weight based on its current share price, which means that companies with higher share prices have a bigger impact on the index’s performance than those with lower share prices. In this index, a company with a lower market capitalization but a higher share price has higher clout than one with a lower share price no matter how large its market capitalization is.

Major stock market indexes

The S&P 500 Index

This is one of the most popular indexes in the investment world. The S&P 500 tracks the performance of the 500 largest companies listed on the stock exchanges in the U.S. Determined by a committee at S&P Dow Jones Indices; this market-cap weighted index has a total market capitalization of $40.3 trillion as of August 31, 2021.

The Dow Jones Industrial Average

DJIA is a price-weighted market index, and its stocks come from a range of sectors like healthcare and tech, among others. As mentioned earlier, the DJIA only contains 30 U.S. stocks, and a committee also determines them at S&P Dow Jones Indices. All DJIA components are “blue chip”, meaning that they are reputable companies known for quality, reliability, and the ability to stay profitable in both good and bad economic times. This index has a total market cap of $10.84 trillion as of June 30, 2021.

The Nasdaq 100

The Nasdaq 100 is a market-cap weighted index. Usually referred to as “tech-heavy” because most of its components are tech stocks, the Nasdaq 100 tracks the performance of 100 of the largest and most actively traded stocks listed on the Nasdaq stock exchange. Apart from tech stocks, the Nasdaq 100 index also contains stocks from other sectors except the financial sector.

The NYSE Composite Index

The New York Stock Exchange (NYSE) is the largest stock exchange globally, boasting a total market capitalization of $26.2 trillion. The NYSE Composite Index, a modified market-cap-weighted index, tracks the performance of all stocks traded on the NYSE (over 2,800).

The Russell 2000 Index

The Russell 2000 Index is different from the others in that it only focuses on the performance of 2,000 of the smallest publicly traded domestic companies. Small-cap companies are those with a market capitalization of between $300 million and $2 billion. This market-cap-weighted index has a total market cap of $3.5 trillion as of July 31, 2021.

The Wilshire 5000 Total Market Index

This index tracks the performance of the entire U.S. stock market.

Apart from the major indexes listed above, there are other market indexes, namely Environmental, social and governance indexes, Global Indexes, National Indexes, Growth Indexes, Value Indexes, and Sector Indexes.