What is a stock index?

Stock market indices (e.g. FT 100 on the FTSE) are measurement tools. They are used by investors to track the market, gauge its performance and then consider the implications of its ups and downs.

Indices are useful because they sketch a broad picture of market trends. Knowing how to read individual stock prices from the financial press is important, but it is equally important to follow general stock market trends, since individual stock prices can perform quite differently from the market as a whole.

How are stock indices calculated?

Index values are recorded continuously throughout the day. At the close of trading each day, you can see the average price movement for the index compared with the previous day's closing value.

Index movements are recorded in points. A rise in an index indicates that the stock market has generally performed well on that particular day; a fall indicates the opposite.

Movements in indices over time act as a kind of economic barometer. A rise is usually a sign of good economic health for a country, whereas a drop over time signifies an economic downturn.

Most indices are weighted. This means that larger companies, as defined by market capitalisation, have a greater impact on the value of the index.

The averaging methods used to calculate the value of indices can differ. Arithmetic averaging involves simply adding the share prices of the component stocks and then dividing by the number of stocks used. Geometric averaging is a bit more complex - the share prices of the component stocks are multiplied together and then raised to the power of 1/n, where n is the number of stocks used in the index.

Types of stock index

Not all indices are the same. Firstly, they contain different numbers of stocks. The UK FTSE-100 contains 100 stocks, while the Dow Jones Industrial Average contains only 30.

Indices can cover whole markets, or just particular sectors of markets. Some cover established blue-chip stocks across the whole market. Others are just based on stocks in particular industries, such as transportation or utilities.

Indices can also record share price movements in different countries. The Nasdaq index in the US, for example, is famous for measuring the performance of predominantly newer, domestic and foreign high-tech companies.

Risks

Although the number of stocks in an index remains constant, the actual stocks in the index may change.

You might see a stock you bought included in an index on the back of a good recent performance on the market. Unfortunately, the reverse can also happen, so buying a leading stock in a closely watched index is no guarantee of making money.

You should not blindly follow one index and or take one index to be always representative of the market as a whole. Generally speaking, the best indices take into account a large number of share price movements in a number of different sectors. A good example of this is the S&P 500, which uses 500 US companies representing the industrial, financial, utility and transportation sectors. Professional money and pension plan managers tend to use these types of indices.