Index Investing: What Is An Index?

Since it would be too difficult to track every single security that trades in the U.S., we take a smaller sample of the market that is representative of the whole – similar to the way pollsters use surveys to gauge the sentiment of the population. That smaller sample is called an index, which is a statistical measure of the changes in a portfolio of stocks representing a portion of the overall market. 

Investors and other market participants 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: If an index goes up 1%, for example, it means the stocks that comprise that index have also increased by an average of 1%.

In 1896, Charles Dow – who with fellow reporter Edward Jones founded Dow Jones & Company – created the Dow Jones Industrial Average (DJIA), the second-oldest stock market index in the world (the oldest is the Dow Jones Transportation Index, also created by Dow). At that time, the DJIA contained 12 publicly-traded industrials, including General Electric – the only original constituent that remains in the index. Today, the Dow is a benchmark that tracks 30 of the largest and most influential companies in the U.S. and is one of the best-known indexes in the world. (For more, see Giants of Finance: Charles Dow.)

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 using a simple average: add up the prices of the 12 companies and divide 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 different methodology called price-based weighting, where the components are weighted in accordance to their prices. To calculate the index, the current prices of the 30 stocks are added together and then divided by what’s known as the Dow Divisor – a number that’s used to maintain the historical continuity of the index. This number is continually adjusted to account for market changes like stock splits, spinoffs and any changes to the Dow constituents. In 2008, for example, the Dow Divisor value was 0.125553. Today, it’s 0.14602128057775.

Most indexes weigh companies based on market capitalization instead of price. If a company's market cap is $1,000,000 and the value of all stocks in the index is $100,000,000, the company would be worth 1% of the index. Indexes are continually calculated to provide accurate reflections of the market throughout the trading session.  

It's important to note that an index is essentially a list of stocks; anybody can create one. This was especially true during the dotcom bull market, when many publications created an index representing a section of new economy stocks. What sets apart the well-known indexes – such as the Dow and the S&P 500 – from the smaller ones is the reputation of the company that puts out the index. For example, the Dow and the S&P 500 are both owned by S&P Dow Jones Indices, the world’s largest global resource for index-based concepts.

Now that we've covered market index basics, let's take a quick look at some of the most popular stock indexes in the U.S. today.