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Stock Index Basics Every Stock Trader Should Know

Jun 2, 2008
A stock index looks at statistical averages for a certain part of the market or a stock exchange. Stocks are included in an index based on common traits--for example, they may be traded on the same exchange; be from the same industry; come from companies of a certain size; or represent a geographic location.

The best-known indexes in the United States are the Dow Jones Industrial Average, the NYSE Composite index, and the S&P 500 Composite Stock Price Index; there are also many others. Stock indexes offer an overall look at the economic health of a particular industry or stock exchange.

Indexes are calculated in a number of ways. A "price-weighted index" is based exclusively on stock prices. This kind of index does not consider the importance of any one stock in the index or the company's size. In contrast, a "market value weighted" index considers the size of the companies. That way, price shifts of small companies have less of an effect than those of larger companies in the index. Another third type of index, the "market-share weighted" index, is based on the number of shares instead of their total value.

In addition to providing an overall assessment of the health of specific economies, indexes can also be a worthwhile tool for investors. For example, "Passively managed mutual funds," a type of fund based on indexes, have been shown to outperform managed funds on a consistent basis. If a mutual fund is based on an index, it duplicates whatever holdings the index is based on. That is, if the NYSE rises by one percentage point, the NYSE-based fund also rises by one percent. This results in lower costs for research and transactions - savings that can be passed on to the fund's investors.

The best-known index in the United States is probably the Dow Jones Industrial Average, which tracks the stock activity of 30 of America's most important companies, such as General Electric, Coca Cola, IBM, and General Motors. As a "price-weighted average" index, it assigns more weight to more expensive stocks. Some analysts believe, however, that this price weighting does not present stock market movements accurately, and they also feel that a group of 30 companies is too small to allow an appropriate assessment.

The S&P 500 Index is based on 500 carefully chosen U.S. companies that represent a wide variety of economic activity. Only the Dow Jones is more influential, and the S&P is considered to be an accurate predictor of the condition of the United States economy.

The FTSE 100 Index is the most influential index outside of the United States. Based on 100 of the largest companies listed on the London Stock Exchange, this index is one of the largest in Europe and is regarded as an indicator of the British economy. The CAC 40 from France and the Nikkei 225 from Japan are other major indexes in other countries.

Those wishing to trade the movements of a particular index have more options than ever. The introduction of ETF's or Exchange Traded funds made it possible for more traders and investors to participate in the movements of an entire index without having to purchase every stock listed in the index. ETF's have now grown to become very popular and therefore very liquid. For instance, the QQQQ, PowerShares QQQ Trust have over 100 million shares traded on a daily basis.
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