The Definition of "Stock Market Index"
A stock market index is a measure of market changes and it shows investors the prevailing mood of the market. Depending on the number of stocks included, an index can be broad- or narrow-based. In terms of how it is calculated, there are two basic types -- capitalization-weighted and price-weighted -- with some new ones emerging.
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Capitalization-Weighted Index
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This type of index shows the average value of the companies included. It is based on companies' market capitalization -- the total amount of money needed to buy all their outstanding shares. S&P 500, Nasdaq and Dow Jones Wilshire all belong in this category.
Variations
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For a capitalization-weighted index, large price movements in the largest components can have a big effect on the value of the index. Some indexes, such as Nasdaq 100, try to correct this by adjusting the weight of individual stocks based on different criteria.
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Price-Weighted Index
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A price-weighted index such as Dow Jones Industrial Average is the one in which stock's influence on the index is proportional to its price. This means that stock with a price of $10 weighs influences the index twice as much as one priced $5.
Fundamentally-Weighted Index
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Based on the belief of some investors that stock price is not always the best indicator of a company's value, these indexes track different fundamentals of a company, such as cash flows, revenue and profit, or dividends.
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References
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