It would be too difficult to track every single security trading in the country. To get around this, we take a smaller sample of the market that is representative of the whole. Thus, just as pollsters use political surveys to gauge the sentiment of the population, investors use indexes to track the performance of the stock market. Ideally, a change in the price of an index represents an exactly proportional change in the stocks included in the index.
Mr. Charles Dow created the first and, consequently, most widely known index back in May of 1896. At that time, the Dow index contained 12 of the largest public companies in the U.S. Today, the Dow Jones Industrial Average (DJIA) contains 30 of the largest and most influential companies in the U.S.
Before the digital age, calculating the price of a stock market index had to be kept as simple as possible. The original DJIA was calculated by adding up the prices of the 12 companies and then dividing that number by 12. These calculations made the index truly nothing more than an average, but it served its purpose.
Today, the DJIA uses a slightly different methodology, called price-based weighting. In this system, the weight of each security is the stock's price relative to the sum of all the stock prices. The problem with price-based weighting is that a stock split changes the weight of a company in the index, even though there is no fundamental change in the business. For this reason, not too many indexes are weighted on price.
Most indexes weigh companies based on market capitalization. If a company's market cap is $1,000,000 and the value of all stocks in the index is $100,000,000, then the company would be worth 1% of the index. These types of systems are made possible by computers - most are calculated to the minute, so they are very accurate reflections of the market.
It's important to note that an index is nothing more than a list of stocks; anybody can create one. This was especially true during the dotcom bull market, when practically every publication created an index representing a section of new economy stocks. What sets the big indexes apart from the small ones is the reputation of the company that puts out the index. For example, the DJIA is owned by Dow Jones & Company, the same people who publish The Wall Street Journal.
Now that we've covered what an index is, let's take a look at some of the most popular stock indexes.
Index Investing: The Dow Jones Industrial Average
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