A stock index is a single number that tracks the value of a group of shares. The Nifty 50, the S&P 500, the NEPSE Index and the FTSE 100 are all indexes. Each one follows a set list of companies, and its level rises or falls as their prices change. An index gives you a quick view of how a market or a part of it is doing, which is why it appears in almost every market report.
An index is simple to read in headlines but easy to misread in practice. Its level depends on the rule used to combine the companies, and the rule can make an index rise even when most of the companies in it fall. This guide explains the main ways indexes are built, how to work out what an index is really measuring, and what to check before you draw a conclusion.
What an index is for
An index has three jobs. It is a benchmark, so an investor can compare a portfolio with the market. It is a summary, so a news report can say how the market did in one sentence. And it is a product, because index funds and some derivatives are built to follow it.
An index does not represent the whole market. It represents the companies chosen by its rules, usually a set number of large or liquid companies. A small company outside the list does not affect the index, however well or badly it does.
Three ways to weight an index
Every index needs a rule for how much each company counts. There are three main methods.
Price-weighted. Each company counts according to its share price, and the index is the average of the prices. A company with a high share price has more influence, whatever its size. The Dow Jones Industrial Average is the best-known example.
Market-cap-weighted. Each company counts according to its total market value, meaning its share price times its shares outstanding. Large companies move the index more. Most of the world's major indexes work this way, including the S&P 500 and many national indexes.
Equal-weighted. Each company counts the same, whatever its size. A small company moves the index as much as a giant one. This gives a different picture of the market, and it changes the risk of the index.
Some indexes use a free-float version of market cap, which counts only the shares that are freely traded rather than all shares outstanding. This matters when a large part of a company is held by a government or a founder, because that part cannot easily be bought or sold.
A worked example: why the direction can surprise you
Suppose an index contains just two companies.
| Company | Price before | Shares | Market value before | Price after | Market value after |
|---|---|---|---|---|---|
| A | 100 | 1 | 100 | 110 (+10%) | 110 |
| B | 50 | 10 | 500 | 45 (−10%) | 450 |
Price-weighted (the simple average of the prices): before, the index is (100 + 50) ÷ 2 = 75. After, it is (110 + 45) ÷ 2 = 77.5. The index rose 3.3 percent, even though one company fell and the other rose by the same percentage it fell.
Market-cap-weighted: before, the total value is 100 + 500 = 600. After, it is 110 + 450 = 560. The index fell 6.7 percent.
The same two price moves produced a rise under one rule and a fall under the other. The method decides the answer, which is why you must know how an index is built before you read its moves.
Why an index can rise while most shares fall
Market-cap-weighted indexes are often driven by a small number of large companies. If three giant companies rise strongly, the index can rise even if most of the other companies in it fall. A headline that says "the market rose" can hide a narrow rally.
Check the breadth of the move. Count how many companies in the index rose and how many fell on the same day, and compare the index move with the average move of the companies. A large gap between the two tells you the index is being carried by a few names. The guide on how to read a country index shows how to run that check.
How indexes are maintained
Index providers review the list on a schedule, usually every quarter or every half year, and sometimes when a major event happens. A company can be added if it grows large enough and meets the liquidity rules, and removed if it shrinks or stops trading freely. Changes are announced in advance, and the funds that track the index must buy or sell shares to follow the change.
This is why a stock can move on the day it joins or leaves an index, even when nothing about the business has changed. The buying or selling pressure from index funds is a known effect, and it is one reason to be careful about stocks that have just been added to a major index.
Indexes also adjust for corporate actions, such as share splits, bonus issues and special dividends. A good index provider adjusts the divisor so that the index level does not jump on those events. You can check the methodology document of any index to see how it handles them.
Price indexes and total return indexes
A price index measures only the change in share prices. It ignores the dividends paid by the companies in it. A total return index adds the dividends back in, so it shows the full return an investor would have earned. Over long periods the difference can be large, because dividends compound. Check which kind of index you are looking at before you compare it with a fund or a portfolio.
What an index cannot tell you
An index does not tell you what your own shares will do. A company can fall while the index rises, and a portfolio can lag an index for years because of the stocks it holds and the costs it pays. An index also has no fees, which is why a fund that tracks it will usually trail it a little.
It also does not measure the whole economy. An index covers listed companies, and the listed companies in a market are not always representative of the businesses in the country. In some markets the index is dominated by a few sectors, such as banks, energy or technology.
How to read an index
- Find the methodology: which companies are included, and the weighting method.
- Check the sector mix: which industries make up most of the weight.
- Look at the largest holdings: how much of the index do the top few companies make up?
- Compare the index move with the breadth of the market: how many companies rose and fell?
- Check whether it is a price index or a total return index.
- Check the date and time of the level you are reading.
Key takeaways
A stock index is a single number built from a basket of shares, and its level depends on the weighting method. Price-weighted, market-cap-weighted and equal-weighted indexes can move in different directions on the same day. A few large companies can carry a market-cap-weighted index, so check the breadth and the sector mix. Read the methodology before you read the headline, and remember that an index benchmarks a market without describing any one company.
This guide is for general information, not financial advice. See the disclaimer.