Stock Market Indices: All You Need To Know

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A stock market index charts the ups and downs of a chosen group of shares, bonds or other type of investment security, making indices an intrinsic component of stocks and shares investing.

Here’s a look at how stock market indices work, along with some of the most familiar index names that the everyday investor will come across.

Remember that stock market investment puts your capital at risk. Investments can fall in value and you may not get your money back.

What is a stock market index?

The world’s first stock index appeared in July 1884 when the ‘Dow Jones Transportation Index’ was published in the US by newspaperman Charles Dow. The index comprised 11 transport stocks including nine railway companies, a steamship company and a telegraph operator.

The index average was calculated by adding all its share prices together and dividing the total by 11 – the number of shares.

In 1896, Dow published an index made up of 12 industrial companies. This evolved into the Dow Jones Industrial Average that traders continue to use to this day.

There’s a more in-depth look at the Dow Jones below, along with profiles of some of the world’s other leading stock market indices. Before that, here’s how stock market indices are put together.

How is a stock market index constructed?

Each stock market index uses its own formula when deciding which companies (or other investments) to include.

Indices that focus on the performance of a wide sweep of the market may only decide to include companies that rank highly in terms of market capitalisation – the total value of all of their shares.

Alternatively, companies may be selected by committee (see S&P 500 below) or represent all the shares that trade on a particular stock exchange (such as London). Some indices focus on companies operating within the same industrial sector, such as technology or healthcare.

Once it’s been decided which companies are to be included, an index compiler then needs to determine how those companies are represented.

This involves a factor known as ‘index weighting’. Depending on how the weighting is attributed, the companies included could each have an equal impact on index performance, or their impact could be based on a consideration such as their market capitalisation or share value.

The three most commonly used index weighting methods are:

  • Market-cap weighted: where an index more heavily represents stocks with the largest market caps. Within this framework, the larger the company, the greater the impact on the performance of an index.
  • Equal-weighted: an index constructed on this basis treats all its participants the same. Each company’s performance has the ability to affect the index by the same amount, regardless of size.
  • Price-weighted: this type of index ascribes the greatest weightings to those companies with the largest share prices, regardless of the actual size of the company.

Major stock market indices

FTSE 100

The Financial Times Stock Exchange 100, also known as the FTSE 100 or ‘Footsie’, is an index of the UK’s 100 largest companies that make up part of the London Stock Exchange (LSE). The LSE itself comprises more than 1,300 companies.

The FTSE 100 is market-cap weighted. For inclusion, a company must be listed on the LSE, be denominated in pounds sterling, and must meet minimum float and stock liquidity requirements. Liquidity is a measure of the ease with which it’s possible to buy and sell a company’s shares.

Stocks with higher market caps have more weight in the FTSE 100 and therefore have a bigger effect on the index’s price movements.

The market cap of each company is reviewed quarterly. If necessary, the index is adjusted with the demotion of companies that have slipped in size, replaced by businesses that have grown sufficiently since the previous review.

Other UK indices include the FTSE 250 and FTSE 350, each reflecting the number of constituent companies, along with the FTSE SmallCap and the FTSE All Share. The All Share is the aggregation of the FTSE 100, 250 and Small Cap indexes. FTSE also includes several indices for so-called Alternative Investment Market or AIM stocks. These represent smaller, growing companies.

S&P 500 Index

The S&P 500 tracks the performance of 500 top US companies, as determined by a committee at S&P Dow Jones Indices. The S&P 500 is a market-capitalisation weighted index.

It includes large, stable companies from across 11 industrial sectors and offers a picture of the health of the US stock market in general and across the broader economy.

Dow Jones Industrial Average

The Dow Jones is another familiar name in the investing world but, in contrast to the S&P 500, tracks the performance of just 30 US companies as selected by S&P Dow Jones Indices. The common denominator among Dow Jones stocks is that they are regarded as “blue chip” companies with a history of strong financial performance. A wide range of industries are featured within the index, from healthcare to technology.

The Dow Jones is one of relatively few price-weighted stock market indices.

Nasdaq 100

The Nasdaq 100 tracks the performance of 100 of the largest and most actively traded stocks listed on the Nasdaq stock exchange. Nasdaq companies are wide-ranging in nature, but generally have a technology bias, with no representation from the financial sector. 

The Nasdaq 100 uses a market-cap weighting.

Nikkei 225

The Nikkei 225 comprises 225 stocks selected from domestic common stocks that trade on the primary market of the Tokyo Stock Exchange. 

The Nikkei is a price-weighted index whose constituents are subject to change annually at the beginning of October. Selection is based on two factors: liquidity and sector balance.

Euro Stoxx 50

The Euro Stoxx 50 is regarded as Europe’s leading blue-chip stock index of Eurozone stocks. It was designed by Stoxx, an index provider owned by Deutsche Börse Group. 

The Euro Stoxx 50 is market-cap weighted and comprises 50 stocks from eight countries: France, Germany, The Netherlands, Spain, Italy, Ireland, Belgium and Finland. Despite its name, about 70% of the index comprises exposure to stocks from two countries: France and Germany.

Hang Seng

The Hang Seng Index is a market-cap weighted stock index and is the main indicator of market performance in Hong Kong. It monitors daily the largest and most liquid 50-60 stocks that are listed on the main board of the Hong Kong Stock Exchange. 

Along with the Nikkei 225, the Hang Seng is one of the best-known indices in Asia.

How to invest in stock market indices

One way to gain exposure to entire stock market indices is to invest in ‘passive’ investments such as index tracker or exchange-traded funds (ETFs).

Each is a form of collective investment that pools the contributions of, potentially, thousands of investors to create one investing pot. You can read about the differences between index trackers and ETFs here.

No stock market investments are guaranteed. But with passive investing, the aim is to replicate the return achieved by a certain stock market index or other benchmark. For example, by copying the performance of the FT-SE 100 index of leading UK companies, or the influential S&P 500 in the US.

Whether you decide to invest in index trackers or ETFs is probably less important than the fact that you’re choosing to invest in passives in the first place. Both types of investment offer lower fees than so-called ‘active’ investments where providers charge more for a more hands-on style of fund management.

Investing in index trackers or ETFs via a stocks and shares individual savings account shelters any returns your investments make from three key areas of tax: income tax, dividend tax and capital gains tax.