What is a stock market index and how does it work?

A stock market index is a calculated measure that tracks the performance of a selected group of stocks designed to represent a market or market segment. When financial news reports that “the market” rose or fell, it is often referring to one or more of these indexes. Understanding what an index tracks and how it is calculated can help you interpret market headlines and compare stock market performance.

How stock market indexes work 

An index provider uses an index methodology, or set of rules, to define the market segment the index is intended to measure. An index may track a broad market, companies of a certain size, an industry or stocks listed on a particular exchange. The provider selects eligible securities, applies a weighting method and uses a formula to calculate a single index level. Components and weights may be reviewed or updated so the index continues to represent its intended market segment.

Two common weighting methods are:

• Market-cap weighting: Companies with greater market capitalization have more influence on the index. Market capitalization, or market cap, is the total market value of a company’s outstanding shares. It is calculated by multiplying the share price by the number of outstanding shares. Some indexes adjust market capitalization to count only shares available to public investors.
• Price weighting: Stocks with higher share prices have more influence on the index. The Dow Jones Industrial Average uses this method.

An index level is a calculated value rather than the combined price of the stocks it follows. Index providers may use an index divisor to help maintain continuity when components change or corporate actions and other nonmarket events affect the index.

Major stock market indexes compared 

Each major stock market index follows a different group of stocks and may use a different weighting method. Reviewing what an index tracks and how it is weighted can help explain what its movement represents.

When comparing the S&P 500 and Dow Jones Industrial Average, the S&P 500 includes more companies and weights them by float-adjusted market capitalization. The Dow follows 30 companies and weights them by share price.

When comparing the Dow and Nasdaq Composite, the Nasdaq Composite includes a much broader group of Nasdaq-listed stocks and uses market-cap weighting. These structural differences help explain why the indexes may rise or fall by different amounts.

What does it mean when a stock market index rises or falls? 

A stock market index generally rises when gains among its weighted components outweigh losses. It generally falls when losses have a greater effect.

A rising index does not mean that each stock in it increased. Gains in higher-weighted stocks may offset declines among other components.

Because each index has its own starting value and calculation method, a point change in one index is not directly comparable with the same point change in another. Percentage changes over the same period provide a more useful comparison of stock market performance.

How to use indexes to measure stock market performance 

A stock market index can serve as a benchmark, or reference point, for evaluating the performance of a market segment or investment.

Consider these factors when comparing performance:

• Choose a relevant benchmark: Compare an investment with an index that follows a similar market segment. For example, the Russell 2000 may provide a more relevant comparison for a small-cap U.S. fund, while the S&P 500 may be more relevant for a large-cap U.S. fund.
• Use the same time period: Compare results over matching daily, monthly, yearly or multiyear periods.
• Check the return type: Price return reflects changes in the prices of the index components. Total return also reflects reinvested dividends under the index methodology. Compare the same return type when evaluating performance.
• Compare percentage changes: Avoid comparing indexes only by their point movements or numerical levels because each index uses a different base value and calculation.
• Review the weighting method: Consider whether market capitalization or share price determines which companies have the greatest influence on the index.

How stock market indexes differ from exchanges and index funds

A stock market index, stock exchange and index fund are related concepts, but they serve different purposes.

“Nasdaq” may refer to the Nasdaq Stock Market or to one of the indexes operated by Nasdaq. The Nasdaq Composite measures the performance of eligible stocks listed on the Nasdaq Stock Market.

Investors cannot invest directly in a market index. An index fund may be a mutual fund or exchange-traded fund, or ETF, that seeks to track the returns of a selected index. Its performance may differ from the index because of fees, expenses and tracking methods.

What stock market indexes can and cannot tell you 

Stock market indexes can summarize a large amount of market information, but they do not provide a complete picture.

Consider these limitations:

• Selected market segment: An index reflects only the securities included under its methodology.
• Weighting differences: Some companies may have more influence on the index than other components.
• Limited economic view: Stock index performance does not provide a complete measure of economic conditions.
• No prediction or personal context: Past index performance does not predict future results. An index also does not account for your financial goals, time horizon or comfort with risk.

Understanding what each stock market index tracks and how it is weighted can make market headlines easier to interpret. Learn more about the basics of investing and the advantages and risks of mutual funds as you explore how investing may fit into your financial goals.