Trillionaire Term of the Day - January 9, 2009

Market Indexes

Indexes are the single most prominent source of information about the financial markets for investors. Every time you turn on a financial news channel like CNBC or open the Wall Street Journal you will see countless references to indexes like the Dow Jones or the S&P 500. You need to know how they’re created and how to interpret the information they report.

In general, a market index is simply a selection of stocks. For example, the Dow Jones Industrial Average is composed of 30 major stocks that people believe to be a good representation of the market.

Different markets are calculated using different methods. Specifically, the Dow Jones is calculated using a “price-weighted average”. The value of the Dow Jones is simply the prices of all its stocks added together divided by the total number of companies. So if the Dow Jones consisted of 3 companies, A (price $10 per share), B (price $15 per share), and C (price $20 per share), then the value of the Dow Jones would be:

                                                    (10 + 15 + 20)

                                    ----------------------------------------       =   15

                                                             (3)

Remember that this is a simplified version. The actual Dow Jones Industrial Average uses a divisor (denominator) that accounts for historical events like stock splits and inflation. So when you see that the value of the Dow Jones is 9000, this number is simply all the prices of its companies stock added together, divided by the divisor Dow Jones creates. This is why the number of the Dow Jones is much larger than an average like 15. The thought process that works for the simplified version still holds with the actual version, so you should use this when interpreting price-weighted indexes.

It is very important to note that the price-weighted average method causes changes in high price stocks to have a much greater effect on the index than changes in low price stocks. This is the same equation for all indexes that use a price-weighted average. If a company like Google (GOOG), that has a price of around $300, loses 10% of its price their stock price would drop $30. If a company like General Electric (GE), that has a price around $16, loses 10% of its stock price then their stock price would drop $1.60. You can see the much bigger effect GOOG has on the index than GE.

But the explanation of indexes doesn’t stop here. The two other most prevalent American indexes are the Standard & Poor’s 500 (S&P 500) and the Nasdaq. These indexes use the “market value weighted method” instead of the price-weighted average method. The market value weighted method is similar to the price-weighted average method, except this form multiplies the stock price times the number of shares outstanding. So let’s say our companies A (price $10 per share, 100 shares outstanding), B (price $15 per share, 150 outstanding), and C (price $20 per share, 200 outstanding) are in the S&P 500 this time. The value of the S&P would be:

                                                                                                                                                                                                                  (10 X 100)+(15 X 150)+(20 X 200))/(3)=2416.7

The S&P 500 and the Nasdaq both also use their own divisors to account for historical stock splits and other changes that would distort their indexes.

Ok, we’re almost there. The last thing that you need to understand is the percentage that is given next to a change in points of the market. Often you’ll see something like “The Dow was down 90 points today (-1%). This percentage is simply the percentage change from the ending value of the Dow the day before. Lets say the Dow ended at 9000 points yesterday. If it loses 180 points today, then the quote would be “The Dow was down 180 points today (-2%) as it settled at 8820.” You could find this percentage by taking the number of points the index gains or loses and dividing it by the ending total of the day before. In our example you would take:

                                                               180

                                                         -------------    =   .02 =  2%

                                                              9000             

So now you (hopefully) understand how the indexes move. But which index should you use to judge the market? The Dow Jones Industrial Average is the most widely referred index because it contains 30 benchmark American companies and it has been around for a long time (since 1896). You should definitely pay attention to the Dow. But as of right now, most investors consider the S&P 500 to be the very best representation of the market for several reasons, including their use of a market value weighted average instead of a price-weighted average.  Most money managers and investors compare their performance to the S&P 500 to judge how well they have done compared to the overall market.

Additionally, you should choose different indexes to analyze different stocks. The S&P 500 only represents Large Cap companies (large companies with a market cap bigger than 10 billion). If you wanted to see how Small Cap companies are doing (market cap form 300 million to 2 billion) you could check the S&P 600. If you wanted to analyze an index that covers almost every company that is publicly traded, you could check the Wilshire 5000.           

I know this stuff is a little confusing, but having a good understanding of what indexes actually mean and how they work will give you an edge over most investors (not many people know what you now know). And any edge in the investing game is invaluable.

-Matt Schwartz

College Trillionaire