Share price index is another name for a stock index. If you’ve ever looked at daily stock price listings in the newspaper, it’s easy to see why investors need some way to summarize all of that information. That’s what a share price index does—it provides a snapshot of what all those numbers indicate for the market or a part of the market. If you plan on investing in stocks, you need to know the definition of a share price index and how indexes are calculated so you can use them effectively to help guide your investment decisions.
A stock index or share price index is an average (usually weighted) of a group of stocks. The oldest index used today is the Dow Jones Industrial Average. It’s a good example to use to understand share price indexes. When it was first published in 1896, the Dow Jones Average was simply the average of the prices of 12 stocks. Over time, new stocks were added and some replaced by others. Any time a change was made, the formula was adjusted to maintain the consistency of the average. That’s true of almost all stock indexes. Although they may start as simple averages, the need to adjust for changes in the makeup of the average makes it necessary to adjust (or “weight”) the index.
There are several categories of indexes. Exchange indexes like the NASDAQ summarize all of the stocks (or a representative sample) that are traded on that exchange. Sector indexes do the same for a particular type of stock. Besides the Dow Jones Industrial Average, there is also a Dow Jones Transportation Average and a Utilities Average. Another type of average is the regional average. Most countries have stock exchanges, and each publishes indexes of its stocks. One example is the All Ordinaries Share Price Index in Australia.
All stock indexes are basically averages, but are adjusted or weighted. There are several reasons why this is necessary. As with the Dow Jones Industrial Average, it may be necessary to replace one stock with another if the company goes out of business or is bought out by another and its stock is no longer traded. An index company’s stock may split. If it then has twice as many shares at half the price, the index has to be adjusted. Some indexes also adjust for the relative size of companies, so the effect of a company with a large market capitalization is balanced properly compared to smaller firms that are included in the index.
Investors find stock indexes useful as a way to judge the overall state of the economy, or of a particular sector of the economy. In general, if economic growth is strong (or at least that indicators show it is likely to improve), an index will rise (which is called a “bull” market). Declining economic conditions or falling corporate profits tend to make indexes fall (a “bear” market).
Some investors decide that the performance of a stock index is a good fit for their investment goals. However, it can be awkward to try to purchase shares in every company in an index such as the Standard & Poor’s 500. Investors can choose mutual funds that hold shares in the companies of an index so the fund’s performance closely tracks the index. This can be a relatively simple way to reduce risk and have what amounts to a diversified portfolio. You can find index funds listed on a number of exchanges. For example, the Standard & Poor’s 500 is listed on the American Stock Exchange with the ticker symbol SPX.