What Is a Composite Index?
A composite index is a collection of a great many equities, other securities, or other indexes that are averaged together to represent overall market or sector performance. Typically, the elements of a composite index are combined in a standardized way to present large amounts of data easily. Indexes are statistical tools, which can provide a useful measure of securities' relative performance over time.
Understanding the Purpose of Composite Indices
Composite indexes are created to conduct investment analysis, measure economic trends, and forecast market activity. They are used as tools for tracking securities' price changes relative 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. Three of the most-followed indexes in the United States are the Nasdaq Composite, Dow Jones Industrial Average (DJIA, the Dow), and the Standard & Poor's 500 Index (S&P 500).
- A composite index is a collection of many securities that are averaged together to represent overall market or sector performance.
- Composite indexes conduct investment analysis, measure economic trends, and forecast market activity.
- The goal of a well-diversified portfolio is usually to outperform the main composite indexes—the Nasdaq Composite, the Dow, and the S&P 500.
The Nasdaq Composite
The Nasdaq Composite was established in 1971 with only 50 companies. Today, it is an index of more than 3,000 common equities listed on the Nasdaq Stock Market. The Nasdaq Composite is calculated using a market capitalization (market cap)-weighted (cap-weighted) methodology.
The Standard & Poor's 500 Index is widely regarded as the best single barometer of large-cap U.S. equities. It contains the 500 largest U.S. publicly traded companies by market value. The S&P 500 also is a cap-weighted index.
Market Cap-Weighted Index
In a cap-weighted index, like the Nasdaq and S&P 500, each component's total market capitalization is proportionately used to determine the index level. In this methodology, components with a higher market cap will have more weight in the composite, and components with a lower market cap will have less weight in the composite. For a stock to arrive at a cap-weighted index's total market capitalization, the price per share of each company is multiplied by its total number of shares outstanding:
Example of a cap-weighted index
- 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 market caps 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, an index divisor would be used to render the index manageable for reporting purposes. In this case, the divisor would be $100,000, and the initial composite level would be equal to $100,000,000 / $100,000 = 1,000.
Real-World Example: The Dow Jones Industrial Average
When you read in the news that the "market is up," they are generally referring to the Dow Jones Industrial Average (DJIA).
The Most Popular Price-Weighted Composite Index
The Dow is the most popular price-weighted composite index. In a price-weighted index, components are weighted by price, not by market cap or shares outstanding. Each stock influences the index in proportion to its price per share. A stock with a higher price will be given more weight than a stock with a lower price, and therefore will have a greater say in the index’s performance:
Example of a price-weighted index
- 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 adding the components, then dividing that sum by the number of components. In this case, the composite level would be $10 ($50 / 5 = $10).