What it is:

A stock market index measures the change in the stock prices of the index ‘s components.

How it works/Example:

Let’s say we want to measure the performance of the U.S. stock market. Assume there are currently four public companies that operate in the United States: Company A, Company B, Company C, and Company D.

In the year 2000, the four companies’ stock prices were as follows:

• Company A     $10
• Company B     $8
• Company C     $12
• Company D     $25
• Total $55

To create an index. we simply set the total ($55) in the year 2000 equal to 100 and measure any future periods against that total. For example, let’s assume that in 2001 the stock prices were:

• Company A     $4
• Company B     $38
• Company C     $12
• Company D     $24
• Total $78

Because $78 is 41.82% higher than the 2000 base, the index is now at 141.82. Every day, month, year, or other period, the index can be recalculated based on current stock prices.

Note that this index is price-weighted (i.e. the larger the stock price, the more influence it has on the index). Indexes can be weighted by any number of metrics, including shares outstanding. market capitalization. or stock price.

When new companies go public or existing companies founder, the indexer may add or delete companies from the index or re-weight the index to accommodate stock splits or other factors .

Why it Matters:

The daily results of stock market indexes are perhaps the most popular numbers cited in the finance and investing world. The Dow Jones Industrial Average (DJIA) is probably the best-known and most widely followed stock market index in the world. It consists of 30 large, publicly traded firms in the United States.

The S&P 500 Index is also very popular. The 500 companies included in the S&P represent over 70% of the total market capitalization of all stocks traded in the U.S.

The Nasdaq Composite is a broad market index that encompasses about 4,000 issues traded on the Nasdaq National Market — virtually every firm that trades on the exchange.

Indices are also used to gauge activity in an economy. Perhaps the best known economic index in the United States is the CPI. or Consumer Price Index, which measures inflation .