Market indexes, primarily stock market indexes, track the price changes of selected groups of stocks. The best known indexes, the Dow Jones Industrial Average, S&P 500 and Nasdaq Composite, track the combined values of 30, 500 and almost 3,000 stocks respectively. The indexes use different methods to determine their values.
There are two main techniques for calculating a stock market index. A price-weighted index gives value in the index to the stocks based on the share prices. The Dow Jones Industrial Average is a price-weighted index. Market-capitalization-weighted indexes give value to stocks based on the total value of the stock outstanding. The S&P 500 is a market-weighted index.
Simple Price Weight Calculation
A simple price-weighted index is the sum of the current price of the stocks included in the index. Charles Dow first calculated the Dow Jones Industrial Average by adding up the prices of 12 well-known stocks. As stock prices move up and down, the simple price-weighted index is recalculated by adding together the current stock prices.
Calculating a market-capitalization-weighted index involves first calculating the market cap of each stock in the index. Market capitalization is the stock price times the number of stocks outstanding, and it represents the market value of the company. A market-cap index will add up the market capitalization value of each stock in the index each time it is recalculated.
Over time, the value of some of the stock in the index will have price changes not caused by market forces. A stock split cuts the stock price in half but does not change the value of the company. Market indexes periodically remove some companies and replace them with other stocks that better fit the objectives of the index. A company in the index might be merged or go bankrupt and have to be replaced.
To keep an index relevant over time, the value needs to be adjusted for these events. The result is a number that is divided into the index calculation after the price-based calculations outlined above are completed. This number that adjusts an index is called a divisor. In early 2010 the divisors were 0.132319125 for the DJIA and 9,027.0176 for the S&P 500.
In a price-weighted index, price changes in the more expensive stocks will have a greater effect on the index value than will changes in less expensive stocks. This can be seen in the DJIA on days when a few expensive stocks, such as IBM, can have an strong effect on the direction of the index. In a market-cap-weighted index, the index value is affected more by the companies with more stock market value. In the S&P 500, the 10 largest out of 500 companies account for 19 percent of the index value.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.