Q: I keep hearing about stock indexes. What are they, and why are they important?
A: A stock index is a measure of average stock prices. Simply put, indexes are numeric gauges of broad market performance. A single number is used to represent the relative price level of a group of individual securities, such as stocks.

There are a number of stock indexes, as well as indexes for other types of investments such as bonds and real estate. The most commonly quoted stock index is the familiar Dow Jones Industrial Average. If you can imagine an asset class, or a subset of a class, there is likely an index that tracks it.

Examples of commonly quoted stock indexes are the Dow Jones Industrials, the Standard & Poor's 500, the Russell 2000 and the NASDAQ Composite. Keep in mind that each stock index measures a different segment of the stock market, by representing the overall price level of that specific group of stocks.

Q: What are stock indexes used for?
A: In the investment world, stock indexes are used as a shorthand method of talking about prices for a segment of the stock market. When a TV or radio station reports on the stock market, they can't possibly read off the prices of thousands of individual stocks. Stock indexes provide a simple, effective means to let investors know the general direction of stock prices that day.

Besides serving as a shorthand measure of prices for groups of stocks, stock indexes are also used as benchmarks against which investment performance for portfolios is measured. For example, many portfolio managers are evaluated according to their returns relative to appropriate indexes.

A third, and very popular, use of indexes is as a way to invest. Index investing refers to the practice of buying all of the components of an index, often through a mutual fund set up for that purpose. Adherents to index investing are adamant that this is a superior method of investing for two reasons: efficient markets and low prices. First, they argue that investment markets are efficient--that is, that no one can consistently pick superior investments because information about securities and markets are available to everyone. Second, the low costs of managing these funds gives them an edge over funds that hire management teams to do expensive research. Another term for index investing is passive investing. Suffice it to say that not everyone agrees that index investing is superior to active management and research, and this long-standing debate rages on.

Q: Who calculates stock indexes?
A: Large, private investment companies such as Dow Jones, Standard amp; Poor's and Morgan Stanley calculate investment indexes, including stock indexes. Widely used indexes help create a prestigious image for these companies, in addition to the income that sale of the data generates.



Q: How are indexes calculated?
A: Index calculation is a very interesting topic, because indexes are calculated in different ways. It is important for consumers to understand the calculation methods involved for the indexes they refer to, because the calculation method has a profound impact on results. In simple terms, we want to know what is being measured.

Most stock indexes give more weight to larger companies. These indexes are referred to as capitalization-weighted (capitalization is simply the total value of the outstanding shares of a company's stock). Since larger companies are weighted more heavily in these indexes, the index is not a valid indicator of the price of the average stock in the index. However, these indexes do give some indication of the price levels of the average investor's holdings, since theoretically there will be more investors in the larger companies. Examples of cap-weighted indexes include the Standard & Poor's 500 Index, and the NASDAQ Composite Index.

The Value Line Composite is a broad stock market index that weights the performance of a broad sample of approximately 1,700 stocks equally. Thus, it is more indicative of the broad stock market, because smaller stocks receive weighting equal to the big guys.

Ironically, the most widely quoted index, the Dow Jones Industrial Average, relies on the most curious method of calculation. The Dow, as it is widely referred to, is price-weighted. Thus, higher-priced stocks receive more weight in this index than lower-priced stocks. The Dow includes 30 blue chip (high quality, large) stocks. The DJIA is calculated by adding the trading prices of the component stocks, then using a divisor that is adjusted for stock dividends, splits and other factors. The average is quoted in points, not dollars.

Q: What are some examples of widely used indexes?
A: At over 100 years, the Dow Jones Industrial Average is the oldest continuing stock market index. The Dow consists of 30 stocks, not all of which are industrial in nature. The sectors represented include financial, food, technology, retail, heavy equipment, oil, chemical, pharmaceutical, consumer goods and entertainment. The most striking similarity of the component stocks is their huge size; each has sales of over $7 billion per year. The DJIA is the best-known market indicator in the world.

The Standard & Poor's 500, also referred to as the S&P 500, is also one of the most popular indexes. The S&P 500 is substantially broader than the Dow, including 500 stocks instead of just 30. As such, it is often used as a benchmark against which portfolio managers are evaluated. Like the Dow, the S&P 500 Index is cap-weighted, meaning larger companies carry more clout in the index.

The NASDAQ Composite Index is increasingly popular, both because of the growing importance of NASDAQ Exchange-listed stocks, and that of technology stocks. The NASDAQ Composite Index includes all of the domestic and foreign companies listed on the NASDAQ Stock Market, almost 5,000 in all. Interestingly, the top few companies are so large compared to the rest of the NASDAQ that the top eight companies make up almost 32% of the entire index.

The Russell 2000 Index is often used as a proxy for small stocks. It is derived from the Russell 3000 Index in the following manner: The Frank Russell Company ranks the 3,000 largest U.S. stocks in terms of market capitalization, and then excludes the largest 1,000, leaving 2,000 smaller stocks. The average market cap of these stocks ranges from about $100 million to $700 million, which are considered "small stocks."

Further Information on Stock Indexes

NASDAQ offers a good compilation of stock market indexes and descriptions at http://www.nasdaq.com/reference/IndexDescriptions.stm

Also recommended: Barron's Dictionary of Finance and Investment Terms. Barron's Educational Series Inc., Hauppauge, NY. ISBN 0764107909.