Even if you’re not sure what stock indices are, you may have encountered them at some point. Turn on a financial TV station, go to the business section of a newspaper, or surf finance sites on the web and there’s a fair chance you’ll see references to the FTSE, Dow Jones, NASDAQ or Nikkei.
But what exactly is a stock index?
You can think of a stock index as a single value representing a ‘basket’ (or set) of shares from a certain section of the stock market.
This could be:
- An exchange (London Stock Exchange, Hong Kong Stock Exchange)
- A region (South America, Europe)
- Or a sector (telecommunications, biotechnology)
The FTSE 100, for example, is a stock index representing the UK’s largest 100 companies as listed on the London Stock Exchange. Should the average share price of these companies rise, so will the FTSE. Conversely, if the average share price drops, the FTSE will fall with it.
Despite speculating on data based on stocks, you are not actually investing directly in the stock market.
Why are indices important?
A stock index enables investors to gain insight into how an entire section of the market is performing, without needing to look at all the individual share prices. For example, the Nikkei 225 index tracks the performance of the 225 largest listed companies in Japan.
Should the index rise, investors would be able to surmise that, in general, Japanese shares are on the up. Consequently, as the index represents all the major companies in Japan, it’s arguably indicative that the entire Japanese economy is doing well.
What are the major stock indices?
Most nations have one major stock index that represents the largest companies in that country. For example:
The US, however, has three main indices:
- Dow Jones Industrial Average (DJIA) – First calculated in 1986, the Dow Jones represents 30 of the most influential companies in the US.
- S&P 500 – The S&P 500 is based on the value of 500 of the largest US companies listed on either the New York Stock Exchange (NYSE) or the NASDAQ exchange. It currently represents around 70% of the total value the US stock market.
- NASDAQ-100 – Established in 1985, the NASDAQ 100 is based on 100 of the largest non-financial companies listed on the NASDAQ exchange.
How are stock indices calculated?
Stock indices are usually calculated in one of two ways:
This system is used by the majority of indices. It takes the size of each constituent company into account when calculating the value of the index as a whole. The more a particular company is worth, the greater effect its share price will have on the performance of the index.
Rather than looking at the overall size of the companies in the index, this system uses their actual share prices. So the higher a company’s share price, the more influence it will have on the value of the index. For example, a stock trading at £50 would have five times more clout than one trading at just £10.
There are only two major indices that use this system: the Dow Jones Industrial Average and Nikkei 225.
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