What is a stock market index, and how is one calculated?

What does a stock market index measure?#

The SEC's investor site describes a market index as something that measures the performance of a "basket" of securities meant to represent a sector of a stock market, or of an economy^[1]. In plain terms, an index is a scoreboard. It picks a group of stocks, applies a set of rules, and turns their prices into a single number that can be tracked day by day.

When a news anchor says "the market fell 1% today", they almost always mean an index fell 1%. Different indexes answer different questions. The Investor.gov glossary gives three U.S. examples: the Dow Jones Industrial Average, an index of 30 "blue chip" stocks; the S&P 500; and the Wilshire 5000, which includes most publicly traded U.S. stocks^[2].

Which indexes do beginners hear about most?#

S&P Dow Jones Indices, the company that runs the S&P 500, describes it as covering 500 leading companies and approximately 80% of available market capitalization^[3]. Its methodology says the S&P U.S. indices are weighted by float-adjusted market capitalization^[5]. The same provider describes the Dow as a price-weighted measure of 30 U.S. blue-chip companies^[4]. Two indexes, two very different formulas.

Other indexes cover smaller companies (Investor.gov mentions the Russell 2000^[1]), single sectors, other countries, or bonds. Rules differ by provider and by country, so it is worth reading what an index actually holds before comparing your results to it.

How does weighting change what an index tells you?#

Market capitalization is the share price times the number of shares — a measure of a company's total market value; see the market capitalization entry. In a market-cap-weighted index, companies with a higher market capitalization make up a greater share of the index^[1]. In a price-weighted index such as the Dow, the price per share determines a stock's weight^[1].

The difference sounds technical, but it changes which stocks drive the headline number. A small company with a high share price can matter more in a price-weighted index than a giant company with a low share price.

Can you invest in an index?#

Not directly. The SEC is explicit: you cannot invest directly in a market index, but index funds track one and so provide an indirect option^[1]. An index fund may hold every stock in the index or only a representative sample^[1]. Our note on index funds covers how they work and what they cost.

A fund will not match its index perfectly. The SEC lists the reasons: an index fund may underperform its index because of fees and expenses, trading costs and tracking error^[1]. So when you compare a fund with its benchmark, expect a small gap — and check that the gap is not large. Small yearly costs add up over time, as our note on investment fees shows.

1. 1

   Read what the index holds

   Large U.S. companies, small companies, one sector, another country? The name does not always tell you.

2. 2

   Check the weighting rule

   Market-cap weighting lets the biggest companies dominate; price weighting lets high-priced shares dominate.

3. 3

   Compare like with like

   Judge a U.S. large-company fund against a U.S. large-company index, not against a global or bond index.

4. 4

   Look at the fund's costs

   The gap between a fund and its index is mostly costs and tracking error over time.

What can an index not tell you?#

An index reports what a basket of stocks did. It does not predict what the basket will do, and it does not describe any single stock in it. On a day when the S&P 500 rises, many of its members may fall. Because the largest companies carry the most weight in a market-cap-weighted index, a handful of big names can move the whole number.

An index that tracks only share prices leaves out dividends. FINRA notes that dividend yield is added to capital gains or losses to determine the total return of a stock or fund^[6], so a price-only figure understates what holders actually received. When you compare a fund with an index, check whether the index figure is labelled "price return" or "total return".

What mistakes do beginners make?#

1. Treating "the market" and one index as the same thing

   The Dow holds 30 stocks; the S&P 500 holds 500; broader indexes hold thousands. They can move quite differently on the same day.

2. Reading index points as dollars

   An index level is just a number built from a formula. A 300-point move means very different things at different index levels — look at the percentage change.

3. Expecting a fund to match its index exactly

   Fees, trading costs and tracking error mean a fund usually lags its index a little. A large or growing gap is worth questioning.

4. Assuming an index is diversified enough on its own

   A market-cap-weighted index can become concentrated in a few large companies or one sector. Look at the top holdings, not just the name.