Sometimes, it is easy to get caught up in financial news, especially if you are a beginner. Analysts and commentators may try to decipher what is happening on the stock market, but the sophisticated terms they use may not help you too much.
You will hear them talk about the bear and bull markets, stock indices, profits, and all that stuff. The problem is that it is easy to get wrapped up in the stock market talk until you forget the basics.
Usually, the stock index is one of the essential parameters on the stock market, and quite often, you will hear a lot of people talking about the major stock indices.
Stock indices are an important factor in stock trading because they are a general representation o what is going on with your investments. In this post, we discuss some of the basic things you need to know about stock market indices.
What is a stock index?
A stock index is simply a measure of a stock market that helps stock investors compare current price levels with past prices to determine overall market performance. Sometimes, an index can represent a smaller subset of the stock market.
Investors use the calculated values of stock market indices as an indicator of the current and future value of different stock components. In fact, savvy investors can use these values to project their returns over time by comparing the present and past stock indices.
The three major stock indices are the Dow Jones Industrial Average index, the S&P 500 index, and the Nasdaq Composite index.
How do stock indices work?
As mentioned above, the primary purpose of a stock index is to show the performance of different entities such as a country, group of stocks within a country or a sector such as the Nasdaq sector which represents stocks from the technology industry.
Technically, it means that if the value of a given stock index goes up or down, that could be the overall indication of how the stocks within that index will perform.
For instance, if the value of the Nasdaq index goes up, it could indicate that the price of all stocks within the technology industry will rise. The same thing applies when the value of the index is moving down.
However, you should keep in mind that the direction of a given stock market index doesn’t necessarily indicate how all the individual stocks within that category will perform.
For instance, you can have the value of some stock indices going up, yet the price of some stocks within the index is dwindling.
How are stock indices calculated?
Before the invention of technology and smart devices, calculating the value of a stock index was not easy. However, things changed with the invention of technology. Today, most stock indices use a weighted average formula to determine the value of the stock index.
The following formula is used in the calculation:
Share price × number of shares/ market capitalization of all shares
Most stock market indices weigh companies by their market capitalization. For example, if the market capitalization of a company is $100,000 and the value of all its shares in the stock market index is $1,000,000, then the company is only worth 1% of the stock index.