What is a 'Composite Index'
A composite index is a grouping of equities, indexes or other factors combined in a standardized way, providing a useful statistical measure of overall market or sector performance over time, and it is also known simply as a "composite." Usually, a composite index has a large number of factors that are averaged together to form a product representative of an overall market or sector.
BREAKING DOWN 'Composite Index'For example, the Nasdaq Composite index is a market capitalization-weighted grouping of approximately 5,000 stocks listed on the Nasdaq market. These indexes are useful tools for measuring and tracking price level changes to an entire stock market or sector. Therefore, they provide a useful benchmark against which to measure an investor's portfolio. The goal of a well-diversified portfolio is usually to outperform the main composite indexes.
Market Capitalization-Weighted Composite Example
In a capitalization-weighted composite, each component's total market capitalization is proportionately used to determine the index level. In this calculation methodology, components with higher market capitalizations will have more weight in the composite, while components with lower market capitalizations will have less weight in the composite. For example, with stocks, the price per share of each company is multiplied by its total number of shares outstanding to arrive at its total market capitalization. For example, consider the following:
Stock A: Price per share equals $25 and total shares outstanding equal 1,000,000
Stock B: Price per share equals $50 and total shares outstanding equal 500,000
Stock C: Price per share equals $50 and total shares outstanding equal 1,000,000
Their respective markets capitalizations would be:
Stock A = $25 x 1,000,000 = $25,000,000
Stock B = $50 x 500,000 = $25,000,000
Stock C = $50 x 1,000,000 = $50,000,000
Thus, the total market capitalization of the composite would be $100,000,000. Stock A's weight would be 25%, Stock B's weight would be 25%, and Stock C's weight would be 50%. Typically, a divisor would be used to make the index a manageable level for reporting purposes. In this case, the divisor would be $100,000, making the initial composite level equal to $100,000,000 / $100,000 = 1,000
Price-Weighted Composite Example
In a price-weighed index, components are weighted by price, not by market capitalization or shares outstanding. The Dow Jones Industrial Average (DJIA) is the most popular price-weighed composite. Components with higher prices receive higher weightings in the composite. For example, take the follow list of five stocks:
Stock A: price equals $3
Stock B: price equals $6
Stock C: price equals $30
Stock D: price equals $10
Stock E: price equals $1
The composite level would be found by summing the components and dividing by the number of components. In this case, the composite level would be 50.