Stock Market Indices Explained: Capitalization-Weighted versus Price-Weighted Indices

You’ve probably seen images of the stock market from television or newspapers – people shouting, waving their arms, running off in all directions – and it may seem like a confusing and strange way for people to make a living.

Actually, the stock market is a surprisingly smooth and efficient way of taking care of two complex and continually changing groups of people from all around the world – those who want to buy the shares of various companies, and those who want to sell.

In this section, you’ll…

• Learn about stock exchanges and indices
• How to retrieve information on a specific index
• How to benchmark your stock’s performance versus an index

Traditionally, when someone refers to the stock market, they are typically talking about the U.S. stock market, and more specifically, the New York Stock Exchange (NYSE). The stock market certainly has more in common with a traditional market, where bargaining is the norm, than your neighborhood shopping mall.

Stock Exchanges Explained

An exchange is a centralized place for trading securities (stocks and bonds) and commodities (bulk goods such as grains, metals, livestock) through an auction-like process.

When you buy or sell a stock, you generally have to specify the particular stock exchange that the company trades on as well. Sometimes, stocks can trade on more than one exchange. When stocks trade on multiple exchanges, they are referred to as being inter-listed.

The major U.S. stock exchanges are the New York Stock Exchange, the American Stock Exchange, and NASDAQ (pronounced “naz-dak”).

An exchange is a centralized place for trading securities and commodities through an auction-like process.  24 brokers subscribed to an original brokers agreement in 1792 forming the first organized stock market in New York.

In addition to the major North American exchanges, there are actually all sorts of different, individual stock markets, or exchanges around the world. Increasingly, as investors become more international, the phrase “the market” could mean stock market activity anywhere from the high-tech heavy NASDAQ index in the United States to the Tokyo Stock Exchange in Japan.

Some stocks aren’t traded on a traditional stock exchange but can still be widely bought and sold through an electronic marketplace. This marketplace is called the Over-the-Counter, or OTC market. Instead of being traded through a centralized exchange, OTC stocks are bought and sold over a telephone and computer network connecting securities dealers.

On any given day when the stock market is “up”, there’s somebody somewhere losing money. And when the market “down”, there is conversely somebody somewhere making money.

“How’s that?” you wonder? Well, suppose the “market” in question is the New York Stock Exchange (NYSE). If somebody says the “NYSE is up”, they are not talking about every stock that trades on the NYSE.

Instead, they are referring to the NYSE index, a list of 30 stocks that make up something called the Dow Jones Industrial Average (DJIA) which is used by investors as a way of measuring or ‘benchmarking’ a stock’s performance in comparison to the overall market – in this case the NYSE.

Did You Know… Index – An index is a composite of stocks, bonds or other securities selected to represent a specific market, industry or asset class. An index is used by investors to measure the overall health of specific markets in comparison to their stock investments.

The 30 companies are chosen by the staff of the Wall Street Journal, and are chosen to reflect the broader U.S. economy. Among the well-known names in the index are Coca-Cola, General Motors, CitiGroup, AT&T, Disney, IBM, Johnson & Johnson, and Wal-Mart.

The DJIA or ‘Dow’ as it’s commonly referred to, is important enough that you’ll almost always hear its performance mentioned in the evening news. You can also keep track of how the ‘Dow’ is faring on most financial web sites.  The Dow Jones Industrial Average tracks the price changes of 30 large and industrial blue-chip stocks that have a combined market value equal to approximately 20% of the market value of all stocks listed on the NYSE.

Did You Know… Dow Jones Industrial Average Often referred to as the Dow, the Dow Jones Industrial Average (DJIA) is the best known indicator of the stock market’s performance. The Dow tracks the price changes of 30 large and industrial blue-chip stocks that have a combined market value equal to approximately 20% of the market value of all stocks listed on the New York Stock Exchange (NYSE).

The Two Types Of Indices

There are two types of indices – market value-weighted indices and price-weighted indices.

Market Value or Capitalization-Weighted Indices

Some indices assign more worth to the movement of those companies that have a larger market or capitalization value. This means that share price fluctuations of big companies count proportionately more than smaller ones, due to their greater number of shares in the market.

Consider the following example:

The share prices of both a large and small company move equally but in opposite directions. The large company’s share price increases by $1, the smaller company’s share price decreases by $1. However, because the larger company has more outstanding shares in the market (100 vs 10), a capitalization-weighted index would still show the market was moving up because the net difference is $90 ($100 – $10 = $90).

Price-Weighted Indices

Some indices ignore the market capitalization of companies and instead account for changes in a company’s stock price. These are referred to as price-weighted indices and since they calculate the average price of their participants, higher priced stocks have a greater influence on index movements than lower-priced stocks.

Price-weighted indices are met with partial criticism, as some financial analysts believe a market-cap weighted index paints a more accurate picture of the stock market.

The Dow Jones, recognized as one of the best measurements of how the U.S. stock market is faring, is a price-weighted index. You should also acquaint yourself with the world’s other major indexes that are commonly used to evaluate a portfolio’s performance.

The DJIA isn’t a measurement of the 30 biggest – or best – blue chip stocks trading on the NYSE. The companies that make it into the index are chosen by the Wall Street Journal to collectively reflect the broader market and U.S. economy.

Putting Indices to Profitable Use

Market indices can help investors in the following ways:

Obtaining Market Snapshots

More than anything else, indexes are useful to get a quick update on where the markets have been, how they have performed, the general direction of stock prices, and overall investor sentiment.

Investing

Maybe you just don’t have the time or energy to research individual stocks on your own. If that’s the case you can still share in the stock market by investing in an index. There are a number of ways to do this, including buying index funds – mutual funds that mirror the performance of a particular index.

Assessing Your Returns

The best way to measure how well your investments have performed is to compare your performance to something else. In the stock market world, that something else is an index.

Indexes are terrific benchmarks to judge your portfolio against. If you are a conservative blue-chip investor, you might compare your results to how the Dow has performed. By contrast, if you’re trying to pick up-and-coming smaller companies you may want to compare that part of your portfolio with the Russell 2000, which tracks the performance of hundreds of small-cap companies.

Or you may simply want to see how a stock has fared, both performance-wise and on the volatility front, versus the overall market.  You can compare the chart of any publicly traded stock vs an index like the S&P 500, NASDAQ, or DOW.

The best way to measure how well your investments have performed is to compare your performance to an index.

Key Learning Points

• The best way to measure how well your investments have performed is to compare your performance to something else. In the stock market world, that something else is an index.
• An index is a composite of stocks, bonds or other securities selected to represent a specific market, industry or asset class.
• There are two types of indices – market value-weighted indices and price-weighted indices.
• Market value-weighted or capitalization-weighted indices account for each stock’s weight in the index proportionately to its market value. This means price fluctuations in big companies within the index count proportionately more than smaller ones.
• Price-weighted indices ignore the market capitalization of companies and instead account for changes in a company’s stock price. This means when the average price of the companies within the index is calculated, the higher priced stocks have a greater influence on index movements than lower-priced stocks.
• Two of the most widely recognized U.S. stock market indices are the Dow Jones Industrial Average (DJIA) and the Standard & Poor’s 500 (S&P 500).
• The Dow (DJIA) tracks the price changes of 30 large blue-chip stocks. Their combined market value is equal to roughly 20% of the market value of all stocks listed on the New York Stock Exchange (NYSE). As the name suggests, the S&P 500 tracks 500 U.S companies on the NYSE, chosen for their market size and industry group.