When you turn to the financial pages or listen to a stock market report, nine times out of 10, the state of the financial markets will be expressed in terms of the Dow, the Nasdaq or the S&P 500. For example, “The Dow closed for the day up 10 points at” The Dow Jones Industrial Average (commonly referred to as the Dow), the Nasdaq Composite and the S&P 500 (Standard & Poor’s) are the most frequently used indexes to measure, track and compare stock market activity.

Comparative measures

An index is a grouping of stocks chosen to represent a certain market segment. They are used to report changes in a financial market, or group of markets, or in the economy as a whole. The value of the index at two different points in time are compared to identify trends, usually expressed as the percentage change on a daily, weekly, 3-month, 1-year, 5-year, 20-year, etc. basis. When Charles Dow introduced the first index on May 26, 1896, the Dow Jones Industrial Average contained 12 stocks, primarily railroads. Dow created the index as a means to gauge how the market was performing in general. Was it rising? Falling? How quickly? Even with the relatively low number of stocks that were being traded at the time, it was difficult for investors to get a feel for the market’s overall direction simply by monitoring the up-a-fourth, down-an-eighth movement of individual shares. A simple average of the 12 stocks’ prices, Dow’s Industrial Average provided a starting point against which the movement of the market could be measured.

Setting the sights

There are many indexes in use today, measuring many different things. The “blueprint” for building an index can vary from objective, rules- and/or numbers-driven formulas to the more subjective selection-by-committee, incorporating criteria such as the company’s reputation or investor interest. Yet because an index is useful only when compared to itself over time, each index has a clearly defined scope.

An index may focus on a specific industry, such as the Nasdaq Financial 100 or the Dow Jones Utilities Index, or on a broad market, such as the Dow Jones Industrial Average, S&P 500 and Wilshire 5000. Indexes commonly select stocks based on market capitalization – the S&P Midcap 400, for example – or may screen for stocks of a certain style, such as the Russell 2000 Growth Index. There probably is an index representing every conceivable combination of any of these factors.

Re-evaluation

To make sure that the index continues to compare apples to apples and not to oranges, the shares that make up a given index must be reviewed periodically to ensure that they remain in line with the selection criteria. The frequency with which the basket of stocks is reviewed and changed (also referred to as reconstitution or rebalancing) varies from index to index. Many are reviewed once a year on a specific day. Others are adjusted monthly. Some rarely change and are reviewed only when specific triggers, such as corporate acquisitions, occur.

Doing the math

The calculations for an index’s value are much more complex today than Charles Dow’s simple average of the 12 stocks’ current prices. Today, most indexes are weighted, usually based on market capitalization. That means changes in a larger company’s stock would have a greater effect on the index than a smaller company. The equation is often adjusted as well to eliminate the effects of stock splits and similar events that would cause the index to move of their own accord even though the value of the underlying company otherwise remains the same.

Next week: Stock indexes and how they work.

Marc A. Pellerin is an associate vice president and investment advisor with Advest Inc. in Lewiston.