A system that measures the value of something in contrast to its previous values or another defined standard or benchmark. It may also be described as a financial instrument used to represent a group of individual prices or data points.
An index is usually calculated as a single value from an array of prices and quantities during a certain period, making it a useful tool for tracking the price of a given asset or basket of assets.
Within financial markets, indexes are often based on a list of various stock quotes and are commonly used to track the performance of the stock market, through a statistical measure of changes - acting as a small sample that represents a bigger portion of the stock market as a whole. Each index follows a particular set of rules and calculation methodology, but ideally, the value variation of an index should reflect an exactly proportional change in the stocks. Therefore, a 5% change in a certain index should represent a 5% change, on average, of all stock markets that are being considered in the calculation.
The DJIA (Dow Jones Industrial Average) and the S&P 500 (formerly Standard & Poor’s 500) are some of the most notable and well-known examples of financial indexes.
Currently, the DJIA index represents the performance of 30 large US companies. Initially, the Dow Jones Index calculation was made by a simple arithmetic average, where the sum of the prices of all stocks was divided by the number of companies in the list. However, the divisor (Dow Divisor) have been adjusted multiple times to reflect structural changes, such as stock splits or stock dividends. Therefore, the index is no longer a simple arithmetic average, but a price-weighted index. Despite being one of the most cited stock market indexes, the DJIA is constantly criticized due to its small sample and to the fact that it does not consider the market capitalization or the relative size of a company.
The S&P 500 is an American stock market index that considers the market capitalization of 500 large companies. The index is based on a weighting methodology, and a committee selects the component companies. When compared to the DJIA, the S&P 500 is considered by many as more a reliable representative of the US stock market performance.
Other examples include the FTSE 100 and the German DAX indexes. The FTSE 100 Index (Financial Times Stock Exchange 100 Index) is a share index that measures a section of the London Stock Exchange, considering the top 100 companies by market capitalization. The DAX (Deutscher Aktienindex) is a German stock index that is calculated based on the 30 major companies that are currently being traded on the Frankfurt Stock Exchange.
While it is impossible to directly invest in or trade indexes, index funds allow individuals to investors their funds based on the performance of an index. For instance, the Vanguard S&P 500 ETF is an index fund that tracks the performance of the S&P 500 index.