What is an Index?
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.
Personalized Financial Plans for an Uncertain Market
In today’s uncertain market, investors are looking for answers to help them grow and protect their savings. So we partnered with Vanguard Advisers -- one of the most trusted names in finance -- to offer you a financial plan built to withstand a variety of market and economic conditions. A Vanguard advisor will craft your customized plan and then manage your savings, giving you more confidence to help you meet your goals. Click here to get started.
Read This Next
We're so used to the idea that we need $1 million or $2 million to retire, that we forget about the real issue when it comes to our retirement spending. There's...Read More →
No one is perfect, right? We've all heard this phrase many times -- and most of realize this is true when it comes to our work and home lives. However, for some reason, many people...Read More →