What is an Index?
An index is a statistical aggregate that measures change. In finance, they usually refer to measures of stock market performance or economic performance.
How Does an Index Work?
Let's say we want to measure the stock price performance of the widget industry. There are currently four public companies that make widgets in the United States: Company A, Company B, Company C, and Company D. In the year 2000, when we started caring about the seedling U.S. widget industry, the four companies' stock prices were as follows:
Company A $10
Company B $8
Company C $12
Company D $25
To create an index, we simply set the total ($55) in the year 2000 equal to 100 and measure any future periods against that total. For example, let's assume that in 2001 the stock prices were:
Company A $4
Company B $38
Company C $12
Company D $24
Because $78 is 41.82% higher than the 2000 base, the index is now at 141.82. Every day, month, year, or other period, the index can be recalculated based on current stock prices.
note that this index is weighted by stock price (i.e., the larger the stock price, the more influence it has on the index). Indexes can be weighted by shares outstanding, market capitalization, or any other factors the indexer chooses. When new companies go public or existing companies founder, the indexer may add or delete companies from the index or 'reweight' the index to accommodate stock splits or other factors.
Why Does an Index Matter?
In finance, the most significant numbers in any given day's news are usually market indices. The Dow Jones Industrial Average is probably the best-known and most widely followed financial index in the world. It consists of 30 of the largest publicly traded firms in the United States. The S&P 500 Index is also very common, comprising over 70% of the total market cap of all stocks traded in the U.S. The Nasdaq Composite is a broad market index that encompasses about 4,000 issues traded on the Nasdaq National Market -- virtually every firm that trades on the exchange.
Indices are also used to gauge activity in an economy. Perhaps the best known economic index in the United States is the CPI, or Consumer Price Index, which measures inflation.