Investment Glossary – Stock Index

“Today, the Dow Jones Industrial Index closed up/down…blah, blah, blah.”

Everyone always talks about “the Dow.” It’s very hip to know exactly where the Dow is. But what exactly is the Dow?

The Dow is a stock index, which in simple terms, is a grouping of a certain type of common stocks so investors can see how that group moves over any given period of time. It provides an easily referenced number that you can look at and quickly see how a number of stocks have changed in value. It does not tell you any information about which of the underlying stocks may have caused its move, but can give you a general idea as to how that subsection of the stock market is reacting to new developments.

Stock indices (which is the plural of “index”) are entirely human creations that are based on our need to organize information so our brains don’t get overwhelmed and shut down because there is too much coming at us. While the Dow Jones Industrial Index is arguably the most famous stock index in the world, there are quite literally hundreds of them. And they can be sorted in all kinds of different ways. You can have indices that are defined by the size of the companies they track. You can have indices that are defined by the industries of the companies they track. You can have indices that are defined by the countries of origin for the companies they track. Name a characteristic, there is likely going to be an index out there that tracks those types of companies – at least short of trying to find one for companies with blue logos or companies that still believe in Casual Friday.

So are all companies represented equally in a stock index?

Another important characteristic to understand about indices, beyond what kinds of companies are represented in them, is how they are weighted with respect to the companies they measure. There are a number of different ways indices can arrive at the weightings of the companies in them called components.

The components could be price-weighted, meaning stocks with the highest price have the greatest representation. An index could be revenue-weighted, meaning the amount of revenue companies generate is the most important factor. Indices are also commonly market-capitalization-weighted, meaning that the market value of the components’ outstanding shares determines their representation. And there are variations on these ideas as well as many other possible weightings, depending on the particular index.

Indices are not stock exchanges, as they do not facilitate trading on their own. Some indices actually track particular exchanges – the NASDAQ Composite as an example. But they do not have to operate in this way. Rather, they are used for measurement and comparison. They’re also as an easy-to-use reference for a certain segment of the stock market. So the next time someone tells you that the Dow was up X number of points, not only will you have a better idea of what that means, but maybe you’ll also be able to talk to them about some of the other indices out there and why they’re important too.