What is a Market Index?
A market index is a metric that tracks the performance of a group of stocks. Some indices are designed to indicate the overall performance of the market, while others follow a particular sector.
How Does a Market Index Work?
There are many types of market indices used to compare stocks, bonds and other investment securities.
A stock index measures the value of a hypothetical portfolio of stocks. Surprisingly, the easy part of composing an index is choosing which stocks to include.
For instance, the Dow Jones Industrial Average consists of 30 bellwether American companies in different sectors. There can not be a significant shift in any industry that will not affect the Dow. With that said, the hard part of making an index is choosing the relative weight of each company.
An popular bond index is the Barclays Capital U.S. Aggregate Bond Index, which can be used as a benchmark to compare treasury bills, corporate bonds, government bonds and foreign bonds.
Different methods are used to calculate a market index's value, such as price-weighting, market-value-weighting and capitalization-weighting, that each have their own set of pros and cons. A variety of these methods are prevalent today, and the mathematical intricacies of each ultimately determine their true usefulness.
Why Does a Market Index Matter?
Taking a look at a market index provides an investor with a quick overview of market trends. Additionally, if a you wish to place a bet on the performance on a certain index, you can usually do so by investing in an ETF that tracks its performance.
For instance, the iShares S&P 500 Index (NYSE: IVV) will yield positive gains when the S&P 500 performs well, while, conversely, the Rydex Inverse 2x S&P 500 (NYSE: RSW) will earn you money if the S&P experiences a downturn.
