Stock Market Index

A stock market index – or simply a market index – is used to evaluate the performance of a stock market or individual sector within the market. For this reason, market indices are often quoted by news services when describing current market conditions. The Dow Jones Industrial Average (DJIA or simply “the Dow”) was one of the earliest market indices and was first released in July of 1896 – it originally consisted of just twelve stocks traded on the New York Stock Exchange.

Today, the Dow continues to be published and it along with the Standard and Poor’s 500 (S&P 500), are considered the most reliable indices for the U.S. markets. Several other indices have also been developed are tied to other markets in the world’s leading trading centers including:

How Indices Are Calculated

A stock index is calculated by selecting a group of representative stocks and using the stock prices to arrive at an index number representing the collection of stock prices. The original Dow Jones contained just twelve firms including such companies as American Cotton Oil, Chicago Gas, U.S. Rubber, and General Electric. When first created, the index was calculated by simply determining the average stock price of the twelve firms; this number could then be compared to the previous day’s index to measure the change in performance of the market from day-to-day.

Over time, some of the original companies went out of business or were absorbed by other firms forcing the list of companies to be regularly updated. Currently, the Dow consists of thirty companies considered to be leaders within the economy, but modifications to the list are common as the status of the underlying companies change. For instance, in September 2008, American International Group Inc. was deleted from the index after government intervention was required to keep the company solvent and share prices plummeted. Kraft Foods Inc. was then added to bring the total number of companies in the index back up to thirty.

The manner in which the Dow is calculated has also changed from the early days and is no longer simply an average of all the stock prices. When the Dow was originally conceived, corporate actions including stock splits and the paying of dividends were not common so there was little need to incorporate these factors into the index. Today, the Dow uses the Dow divisor to account for corporate actions and the divisor is continually adjusted to ensure the index accurately reflects price changes in the stocks – this is known as the price-weighted method.

One problem associated with this means of calculating the index is that a one dollar change in a stock priced at $2 makes a much greater difference when expressed as a percentage than a one dollar fluctuation in the price of a stock priced at $50 a share. For this reason, many of the other major indices – including the S&P500 – use what is known as the market-capitalization weighting approach to determine the index.

Market-capitalization weighting takes the full market value of a company’s outstanding shares into account when calculating the index. For example, if Company ABC is worth $10 billion compared to Company 123 which has a market capitalization of $5 billion, Company ABC will be weighted 2-to-1 when calculating the index. This makes a one dollar change in Company ABC affect the index to the same degree as a one dollar change in Company 123.

Using Indices to Determine Management Effect

Because market indices are calculated on a regular basis and in a consistent manner, they serve as benchmarks illustrating the overall performance of a given market. The benchmark can then be compared with results obtained by portfolios actively managed by an investment professional. This is important because it enables investors to compare how well their managed portfolios have faired in relation to the market.

For example, if the Dow gained 5 percent over the course of a year, this means that an unmanaged portfolio would be expected to also gain about the same – this is referred to as passive account management. Using this logic, if a portfolio actively managed by an investment manager returns 7 percent over the same time, you can assume that the extra 2 percent realized was due to the efforts of the investment manager – this is referred to as the management effect.

As an investor this is important information for you as it helps you asses how effectively your investment manager has been regarding your investments. Consider the scenario above – if the fees paid to your investment advisor were less than the extra two percent attributed to the management effect, you would benefit from a positive management effect. On the other hand, if the fees exceeded the management effect – or worse still your portfolio actually underperformed the index – you would have been better off without your advisor. This is an example of negative management effect.

Related Links

Dow Jones Industrial Average website

Stock Market Index Futures