Stock market indices are valuable tools for all types of investors. Whether you are day-trading the market for quick profits or investing for retirement, you should understand and actively use indices. They help distill a large body of information into a single figure, measure your performance against benchmarks and identify trading opportunities.
A stock market index essentially tracks the performance of a group of stocks. In the case of the Dow Jones Industrial Average, this group is made up of only 30 stocks, while the S&P 500 consists of 500 different stocks. When you hear that the Dow is up 5 percent since the beginning of the year, this means that if you had purchased an equal dollar amount of all 30 shares making up the Dow on Jan. 1 of the year, your investment would have grown by 5 percent.
Generally, calculating an index is fairly easy. If the index weight of each share is equal, calculate the average prices of stocks to arrive at the index value. If, however, stocks have different weights -- for example, a weighting determined by the market value of each company -- you need to multiply the price of each stock by its index weight and sum up the results. The process becomes a bit more complicated if some of the stocks "split," meaning each old share is replaced by several new shares, or there are dividend payments. To accurately assess the impact of such events, you will need to adjust the prices before averaging them.
Creating Custom Indices
You can create a custom index by selecting a group of stocks whose performance you wish to track as a group. If you have an online brokerage account, the process of creating a custom index merely involves choosing the shares that make up the index. The index value is then calculated by software, which will make all necessary adjustments for such events as splits and dividend payments. When selecting stocks, you can focus on, among other parameters, a specific sector, such as mid-sized restaurant chains, regions, such as the West Coast or Midwest, or risk, such as high-risk energy stocks.
Investors most commonly use indices to assess their performance. If the three stocks of mid-sized restaurants in your retirement account are up only 2 precent, while the index of mid-sized restaurants has gained 4 percent during the same period, you know you have made poor stock selections. Another way to use indices is to compare one index against another to identify opportunities. If the Dow and S&P are both up 5 percent and the airline index is up a mere 0.5 percent during the same period, airline stocks may have become relatively cheap and might warrant a second look. Before investing cash, you must of course consider several other sector-specific issues.