What Are Stock Market Indexes?
A stock index is a basket of stocks which measures the performance of the stock market or at least a portion of a stock market. This could be globally, in a specific country, or even for a particular industry.
Most indexes tend to work in a similar way, we’ll focus on the S&P 500 as our example, but the concepts largely apply to other indexes too.
The S&P 500
The S&P 500 index tracks the performance of stocks for the top 500 companies based in the United States. What dictates a top company? Well, the S&P likes to use market capitalisation, or just market cap for short.
Market cap is the total value of all the companies' shares. When you hear that Apple is valued at a few trillion dollars, that’s the market cap, the value of all the companies shares.
Let’s assume a company has 100 shares issued, with each valued at $10. That means the market cap would be $1000. For the S&P500, the total market cap is in the multi-trillions. There’s no point in me giving you a value here as the value of the individual stocks move up and down all the time.
However, not all the companies represented within the index are equal. They are weighted towards the biggest companies with the biggest market cap.
For example, Apple is one of the biggest companies in the S&P500. On the other end, Alaska Air Group, is one of the smallest. That means Apple would have a much bigger weighting in the index. The changes in the value of Apple stock will impact the S&P500 more than Alaska Air would. Any changes in the value of Alaska Air will barely have any impact on the index.
From a more practical point of view, that means when we’re tracking an index, perhaps you’re looking to invest in one, it’s those top companies in the index that will have the most impact on the value.
Other Indexes
That’s just one example of an index. There are thousands of indexes out there, and the ones you choose to follow depends on what your objectives are. There are also indexes that track mid and small cap stocks, and specific industries such as energy, healthcare, defence and so on.
Whatever industry, or country you want to track, you can probably find an index for that. However, you can’t actually trade or invest in an index, not directly anyway.
If you wanted to trade an index, there are two main ways you could do it. The first would be to create a portfolio and buy the stocks to match the index you’re tracking. However, this isn’t really that practical because to recreate the S&P500, you would have to purchase 500 stocks. The fees, and the amount of capital you’d need may be quite high.
The alternative is to use some kind of index tracker. These are derivatives that are designed to track the performance of an index, but you don’t hold the underlying shares. There are many different types of derivates you can use, such as CFD’s and futures markets. These are better for shorter-term trading as they usually have a higher cost to hold a trade.
If you’re looking to invest long-term, you may use a tracking index offered by brokers such as Vanguard which are usually lower cost, but the transaction can take a few days up to a week to complete.
Overall, an index is just a tracker for the stock market, with many different types of indexes available. Whatever your objective is, you can probably find an index which will give you a diversified way to trade a market compared to picking individual stocks.