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Stock market index

 

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A stock market index is a tool for measuring the performance of an entire stock market or group of related stocks. These indices are often associated with particular stock exchanges or industries. They exist because changes in a market index can reflect a more general price trend than a change in individual stock prices.

There has been an accelerating trend in recent decades to create investment funds that are based on market indices. These are called index funds.

The most regularly quoted market indices are those including the stocks of the largest listed companies on a nation's largest stock exchange. Examples include the American Dow Jones Industrial Average, the S&P 500, the British FTSE 100, and the Japanese Nikkei 225. However, because of the concentration on a relatively few very large stocks, such indices can give a misleading picture of market trends.

More specialised indices exist tracking the performance of specific sectors of the market - for instance, there are national indices for mining companies, or companies that mine a specific commodity, small companies, technology companies, and even very specialised indices such as one by Linux Weekly News tracking stocks of companies that sell products and services based on Linux.

Ethical stock market indices

A notable specialised index type is those for ethical investing indices that include only those companies satisfying ecological or social criteria, e.g. those of The Calvert Group, Domini, and the Dow Jones Sustainable Index.

Another important trend is strict mechanical criteria for inclusion and exclusion to prevent market manipulation, e.g. as in Canada when Nortel was permitted to rise to over 50% of the TSE 300 index value. Ethical indices have a particular interest in mechanical criteria, seeking to avoid accusations of ideological bias in selection, and have pioneered techniques for inclusion and exclusion of stocks based on complex criteria. Another means of mechanical selection is mark-to-future methods that exploit scenarios produced by multiple analysts weighted according to probability, to determine which stocks have become too risky to hold in the index of concern.

Critics of such initiatives argue that many firms satisfy mechanical "ethical criteria", e.g. regarding board composition or hiring practices, but fail to perform ethically with respect to shareholders, e.g. Enron. Indeed, the seeming "seal of approval" of an ethical index may put investors more at ease, enabling scams. One response to these criticisms is that trust in the corporate management, index criteria, fund or index manager, and securities regulator, can never be replaced by mechanical means, so "market transparency" and "disclosure" are the only long-term-effective paths to fair markets.

The Dow Jones Industrial Average is *NOT* an Index

The Dow Jones Industrial Average is not an index, because it is price-weighted and not market-capitalization weighted. Technically, an index must be market-cap weighted. It is impossible to buy-and-hold a collection of stocks that give you the same return as the Dow, because it is price-weighted.

Historically, the Dow is price-weighted because that is the easiest way to compute a composite. With computers, it is possible to create a market cap-weighted composite, which can be mirrored by an investment strategy.

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