Most of us have heard of stock indexes, but have only a fuzzy idea of them at best. This article aims to clarify some of the basics of stock indexes -- what they are and how they work.

What Is A Stock Index?

A stock index is simply an average price for a large group of stocks, either those on a particular stock exchange or stocks across an entire investing sector. Indexes are formed from stocks with something in common: they are on the same exchange, from the same industry, or have the same company size or location. Stock indexes give us an overall snapshot of the economic health of a particular industry or exchange.

Many stock indexes exist; in the United States the most well known are: the Dow Jones Industrial Average, the New York Stock Exchange Composite index, and the Standard & Poor 500 Composite Stock Price Index.

How Does It Work?

There are several ways to calculate an index. An index based solely on stock prices is called a "price weighted index." This type of index ignores the importance of any particular stock or the company size.

A "market value weighted" index, on the other hand, takes into account the size of the companies involved. That way, price shifts of small companies have less influence than those of larger companies.

Another type of index is the "market share weighted" index. This type of index is based on the number of shares, rather than their total value.

Index As Investment Tool

Another huge function of indexes is that they can function as investment instruments in and of themselves. Mutual funds based on an index duplicate the holdings of the underlying index. Thus, if index A rises by 1%, the Index A Mutual Fund rises by 1%. This has the tremendous advantage of lower costs. Plus these index funds have been shown to generally outperform managed funds.

The Big Indexes

One of the best-known indexes in the world is the Dow Jones Industrial Average. It is a "price-weighted average" index composed of the stocks of 30 of the most influential companies in America. Some feel that 30 companies are not enough to form an accurate assessment for so influential a measurement, but it is reported around the globe daily nevertheless.

The Standard & Poor 500 Index is based on 500 United States corporations, carefully chosen to represent a broader picture of economic activity.

Beyond the United States, the most influential index is the FTSE 100 Index, based on 100 of the largest companies on the London Stock Exchange. It is 1 of the most important indexes in Europe. 2 other important indexes are France's CAC 40 and Japan's Nikkei 225.