How to Calculate an Index

Research your options carefully before investing

Creating an index requires developing a popular asset class of investments and then finding, weighting and correlating the best mix of securities representative of the index. Index building is a meticulous process that requires strong statistical skills and knowledge of how individual stocks trade in varying market conditions.

Instructions

1. Develop a list of possible securities for the index. Note the price, dividend, market capitalization, industry and sector. Eliminate stocks that do not meet geographical, price, yield or credit quality.

2. Determine a weighted average index like the S&P500 or the NASDAQ by weighting each stock price by its capitalization (the stock price multiplied by the number of shares outstanding). For example, a $1 billion company would have half the weighting of a $2 billion dollar company. This is regarded as the more accurate method of index creation.

3. Use the index to calculate the movement of different sectors, trading styles and market capitalizations. In each case construct the index so that it is representative of the market you are measuring. An index must have a list of distinguishing characteristics that may include dividend requirements, geographical location, capitalization or purpose. Make sure every stock fits the requirements of the index.

4. Test the index you created by tracking how it would have performed in the past. Test to see if it accurately tracks what it was intended to measure and if it is reliable as a hedge or a proxy for the sector you are measuring. Use statistical correlation to determine goodness of fit.

Tips & Warnings

• There are numerous statistical techniques to use when choosing how to weight securities in an index. Use some form of weighting to properly adjust the value of large and small companies in a bankruptcy. An index can be either weighted or unweighted. The Dow Jones Industrial Average is unweighted. It simply represents the average of the 30 major stocks that make up the average.

References

• PDF on How the S&P500 is Created