What is an Index

What is an Index? This is a question commonly asked when a person is attempting to become financially literate. Fortunately the answer is rather simple: A financial Index is a grouping of stocks that meet a predetermined criteria.

Upon reading this your first thought is probably, “Great, I have no idea what that means!” Do not fret as I shall explain the mystery away. The first part of the above definition says that an index is a group of stocks. The number of stocks in this grouping can range all over the number spectrum. One of the most commonly followed index, the Dow Jones Industrial Average, only includes 30 stocks. In direct contrast is the Wilshire 5000 index with more than 6000 stocks. As you can see the number of stocks an index includes varies greatly.

The last part of our definition says that stocks must meet predetermined criteria to be included in the index. This is true for every index in existence today. The Wilshire 5000 index, referenced above, has a very simply criteria: US headquartered equity securities with readily available price data.

As you might guess this means that the Wilshire 5000 includes every stock that trades on the NYSE, NASDAQ, and American Stock Exchange. Such a broad stock exposure makes this index a good indicator of the overall US market. On the other hand the Dow Jones Industrial average has much stricter criteria for inclusion: The stocks included are selected by the editors of The Wall Street Journal.

One might expect the smaller number of stocks and the criteria used to select them would hamper this index. Interestingly, the Dow has proven to be a good indicator of the US market over the last century.

One final factor that we can not neglect is how an index is weighted. In other terms this means how much of each stock should be included in the index. The most common weighting scheme is called market-cap weighting which gives large stocks more influence over their smaller counterparts. Look for more information on the various weighting techniques in a future article.

Thanks for reading and hopefully the question, “What is an Index”, will never plague you again!