
Stock Market Indexes
Investment Snapshot
* The Dow Jones Industrial Average increased by 212
points on one day of trading, indicating stock market
euphoria.
* In July 1998, the Nasdaq Composite Index reached 5,000,
and eight years later, the index hovered around the 2,000
level.
* Citigroup has developed a market sentiment index
model that indicates whether stock market investors are
euphoric or in a state of panic
The stock market indexes are viewed as the vital signs for predicting
the direction of the stock market. Not only do the stock market
indexes influence the investment behaviors of individual investors,
but they also influence the investment decisions of investment
professionals (fund managers).
RETURNS AS MEASURED BY THE STOCK MARKET INDEXES
A number of stock market indexes give you different measures of
the stock market. You can use these indexes in the following ways:
1. To determine how the stock markets are doing
2. As comparison benchmarks for the performance of your
individual portfolios, mutual funds, and exchange-traded
funds
3. As forecasting tools for future trends
These market indexes give you a glimpse into the movement of
individual stock prices. However, you should understand the relationship
between the indexes and individual stocks before taking
any action. In general, the different stock market indexes move up
and down together by greater or lesser amounts, although they
sometimes diverge. Figure 6–1 presents a comparison of the three
major stock market indexes. These differences are due to the composition
of stocks in each index, the manner in which each index is
calculated, and the weights assigned to each stock.
An aggregate measure of the market is calculated as an average
or an index. An average is calculated by adding stock prices and
then dividing by a weighted number to give an average price. An
index is a weighting of stock prices related to a base year’s stock
prices. Examples are the Standard & Poor’s (S&P) 500 Composite
Index, the New York Stock Exchange Composite Index, and the
OTC Index (over-the-counter stocks).
Figure 6-1
Comparison of Market Indexes, 1988–2005

The relative weighting of the individual stocks in each index
differs. A price-weighted index is composed by adding the share
price of each stock in the index and then dividing by a number that
is adjusted for stock splits. The Dow Jones Industrial Average is
calculated on a price-weighted average. A market-value-weighted
index is compiled using the market value of each company in the
index. The weighting of each company is determined by its market
capitalization, which is the market price of the stock multiplied by
the number of shares outstanding. Consequently, a company with
a larger market capitalization will have a greater weighting in the
index. Stock splits do not affect the index. The S&P 500 Index is a
market-value-weighted index.
An equally weighted index is computed by giving each stock the
same weight regardless of price or market capitalization. The
equal-weighting method places an equal dollar value on each
stock, in contrast to price weighting, which uses an equal number
of shares of each stock, and market-value weighting, which views
stocks in proportion to their market capitalization. An equally
weighted index can be calculated using an arithmetic or geometric
method. The Value Line Index uses the geometric method.
These differences explain the discrepancies between the rates
of return of the different indexes. Following is a discussion of the
most widely used stock indexes.
KEY CONCEPTS
* Returns as measured by stock market indexes
* Determining which index to use in evaluating your portfolio
* The importance of stock market indexes
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