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Understanding Stock Market Indices
A stock market index tracks the performance of a selected group of shares, bonds, or other investment securities. Indices play a crucial role in stocks and shares investing by providing insights into market trends and performance.
What is a Stock Market Index? The concept of a stock market index dates back to July 1884 when the Dow Jones Transportation Index was introduced by Charles Dow in the US. This original index included 11 transportation-related stocks, such as railway companies and a steamship company, and was calculated by averaging their share prices.
In 1896, Dow introduced the Dow Jones Industrial Average, a broader index comprising 12 industrial companies. This index has evolved into a key indicator used by traders today.
How Are Stock Market Indices Constructed? Each stock market index has its own method for selecting and representing the companies or securities it includes:
- Selection Criteria: Indices may focus on a broad market overview by including top companies based on market capitalisation (the total value of all their shares). Alternatively, companies may be selected by a committee or represent all shares listed on a specific stock exchange. Some indices focus on specific sectors, like technology or healthcare.
- Index Weighting: Once companies are chosen, their influence on the index is determined by a process called 'index weighting.' Depending on the index, weighting may be equal for all companies or based on factors such as market capitalisation or share value. This determines how each company's performance affects the overall index.
Popular Indices to Know:
- Dow Jones Industrial Average: One of the oldest and most well-known indices, tracking 30 major US companies.
- S&P 500: Includes 500 large-cap US companies and is often used to gauge the overall US stock market performance.
- FTSE 100: Represents the 100 largest companies listed on the London Stock Exchange.
- Nasdaq Composite: Covers all stocks listed on the Nasdaq stock exchange, including many technology companies.
Understanding these indices helps investors gauge market trends and make informed investment decisions.
