An index tracks the prices of a specifically selected group of securities to measure the performance of the financial market or market segment to which the securities belong. A financial market can be defined in a variety of ways—by asset class, security size, risk level, geography, and a variety of other factors. For example, an index might track large-company US stocks, corporate bonds issued in developing markets, or global oil prices, to name just a few. An index can be broad—tracking hundreds or sometimes thousands of securities—or narrow—tracking only a few—or somewhere in between.
But what each of an index’s components must have is a publicly available market price. Without a price, there can be no calculation. And if the price isn’t publicly available, there’s no way to be sure that the index is objective and therefore a reliable indicator of performance.
As an index moves up or down to reflect gains or losses, the change is expressed both numerically and as a percentage. Percent change is generally considered a more revealing indication of what happened in the market during the time period being measured— seconds, hours, days, weeks, or longer. Percent change lets you compare the performance of different market segments, such as large- and small-cap stocks, or of the same market sector in different regions, such as the United States and Europe.
Every index has a methodology, or set of rules, which states the index objective, the market it will track, and the criteria that will determine which securities are eligible for inclusion. Methodology, in fact, governs every facet of an index’s creation and operation and underlies its reliability and credibility. Methodology is also the reason that two indexes tracking what seems to be the same market produce different results. In a small number of indexes, including two of the best-known and most-widely used—the Standard & Poor’s 500 Index (S&P 500) and the Dow Jones Industrial Average (DJIA)—final decisions about the composition of the index are made by an index committee choosing among qualifying securities. In other cases, index components are determined statistically, based on the index’s methodology.
Contributions from the book Index Investing in this press release are used with permission from Light Bulb Press.