What it is:
How it works (Example):
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.
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 it Matters:
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.