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Common Stock Index

Original post by Victoria Duff of Demand Media

The first stock market index, the Dow Jones Industrial Average, was created in 1896 by Charles Dow, editor of "The Wall Street Journal" and founder of Dow Jones and Company. He compiled the index to create a way for investors to measure the performance of the overall stock market, and it was joined in 1896 by the Dow Jones Transportation Average and, in 1929, by the Dow Jones Utility Average.

Major U.S. Indexes

Since creation of the Dow Jones Indexes, hundreds more stock market indexes have been created globally, with the Standard & Poor 500 (S&P 500) being the bellwether in the United States. When the financial news reports on general market movement, the S&P 500 is the measure used unless the Dow Jones Industrial Average (DJIA) is specifically mentioned. The S&P 500 is a broader sampling than the DJIA, which contains only 30 or the largest capitalization stocks traded on the New York Stock Exchange. Other popular indexes in the United States include the Russell 3000, the Dow Jones Wilshire 5000, the NYSE Composite and the NASDAQ Composite. Composite indexes cover all issues traded on the NYSE or NASDAQ. The Russell 3000 lists the largest 3000 U.S. companies, or approximately 98 percent of the U.S. stock market. The Wilshire 5000 is designed to track a broader number of publicly traded companies.

How Indexes Are Calculated

A stock market index is generally calculated by combining a weighted average of a set of particular stocks. The DJIA is calculated by combining the price of each of the 30 stocks in the average, divided by the Dow Jones Divisor, which accounts for stock splits and companies that enter and exit the DJIA. Each time a Dow stock splits, or a new company is swapped into the average, the Divisor changes. Calculations of the DJIA are just an example of the basic method for calculating a stock index, and most follow approximately this formula, though some may use proprietary algorithms.

Benefits for Investors

A stock market index allows investors to follow fluctuations in the overall trading progress of the broad stock market. Charts of the averages' open, high, low and closing prices and volume allow technical analysis of the market's historical performance and projection of its likely future performance. Mutual funds and exchange traded funds (ETF) are often structured to clone one of the indexes, allowing investors to diversify their holdings over the broad market, keeping returns on investment locked to broad market performance and doing this without having to invest more than a modest amount of money.

Drawbacks

A stock market index can also be misleading. In the DJIA, for example, companies with the largest market capitalization -- the total number of shares outstanding multiplied by the stock price -- can skew the DJIA if an event causes one of these stocks to fall or rise by an unusual amount. That is why many investors also pay attention to the broader market indexes such as the S&P, Russell or Wilshire. Also, when all the indexes are dropping, there are often individual companies that are making higher prices, if not new highs. An old Wall Street saying warns that it is a market of stocks, not a stock market.

                   

References

About the Author

Victoria Duff specializes in entrepreneurial subjects, drawing on her experience as an acclaimed start-up facilitator, venture catalyst and investor relations manager. Since 1995 she has written many articles for e-zines and was a regular columnist for "Digital Coast Reporter" and "Developments Magazine." She holds a Bachelor of Arts in public administration from the University of California at Berkeley.

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