What is an index?
An index is a combination of several stocks, usually from the same country or region, which represent a market as a whole and allow simple tracking of the market over time. Indices are usually weighted using either market capitalisation or price. In an ideal world, changes in the price of an index will proportionately represent a change in the price of the stocks within.
Examples for indices
The most well known index in the world is the Dow Jones Industrial Average (DJIA), more commonly known as the Dow which contains 30 of the largest and most powerful public companies in the US.
The DJIA is a price weighted index meaning it is calculated simply by taking the sum of all of the stock prices within the index and dividing by a specific divisor (The Dow Divisor in this case). Back in 1896 when Charles Dow and Edward Jones created the index no one foresaw the introduction of stock splits and so the index was calculated by adding the price of all 12 (at the time) stocks and dividing by 12, making it a basic average.
The FTSE100, created by the Financial Times and London Stock Exchange in 1984 comprises the top 100 companies in the UK and is seen as an indicator for prosperity. The FTSE100 is a market capitalisation weighted index meaning the larger a company is, the more effect it will have on price movements in the index.
Take Royal Dutch Shell for example, with a market cap of £185bn the effect of a price change here will be much greater than the effect of a price change at Royal Mail with a market cap of just £4.6bn.
Who can create indices?
The strange thing is that anyone can create an index, in reality it’s just a list of stocks which may or may not be weighted in some way. The problem is reputation, the only indices that really matter are the ones created by reputable companies, look back to the FTSE, is it owned by the Financial Times and The London Stock Exchange, two incredibly reputable companies within the industry.