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I am new to finance and find it difficult to understand how stock market indices are calculated and what they really represent.

It seems like a more simple way to create an index would be to simply sum the total market capitalization of companies in a basket. This sum would constantly fluctuate and provide an indication of how well the market is doing.

I'm sure there is a flaw in my reasoning and would like to understand what it is.

  • but share price fluctuations change the market cap... they are the market cap – CQM Dec 19 '16 at 5:10
  • Sure and...? Wouldn't an aggregate of market caps measure the value of a section of the stock market? – Olivier Lalonde Dec 19 '16 at 6:06
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    I also thought that this is how market indexes actually work. It would make sense that they are represented as smaller numbers, just because "2168" is easier to remember than $19,931,167,000,000. But comparing the past values here, the index value doesn't follow total market cap: siblisresearch.com/data/total-market-cap-sp-500 – jpa Dec 19 '16 at 6:23
  • Reading investopedia.com/ask/answers/05/sp500calculation.asp I feel like my intuition was right and "weighted average market capitalization" indices are actually computed from the sum of all market caps. – Olivier Lalonde Dec 19 '16 at 21:39
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They do but you're missing some calculations needed to gain an understanding. Intro To Stock Index Weighting Methods notes in part:

Market cap is the most common weighting method used by an index. Market cap or market capitalization is the standard way to measure the size of the company. You might have heard of large, mid, or small cap stocks? Large cap stocks carry a higher weighting in this index. And most of the major indices, like the S&P 500, use the market cap weighting method.

Stocks are weighted by the proportion of their market cap to the total market cap of all the stocks in the index. As a stock’s price and market cap rises, it gains a bigger weighting in the index. In turn the opposite, lower stock price and market cap, pushes its weighting down in the index.

Pros

Proponents argue that large companies have a bigger effect on the economy and are more widely owned. So they should have a bigger representation when measuring the performance of the market. Which is true.

Cons

It doesn’t make sense as an investment strategy. According to a market cap weighted index, investors would buy more of a stock as its price rises and sell the stock as the price falls. This is the exact opposite of the buy low, sell high mentality investors should use.

Eventually, you would have more money in overpriced stocks and less in underpriced stocks. Yet most index funds follow this weighting method.

Thus, there was likely a point in time where the S & P 500's initial sum was equated to a specific value though this is the part you may be missing here. Also, how do you handle when constituents change over time? For example, suppose in the S & P 500 that a $100,000,000 company is taken out and replaced with a $10,000,000,000 company that shouldn't suddenly make the index jump by a bunch of points because the underlying security was swapped or would you be cool with there being jumps when companies change or shares outstanding are rebalanced? Consider carefully how you answer that question.


In terms of histories, Dow Jones Industrial Average and S & P 500 Index would be covered on Wikipedia where from the latter link:

The "Composite Index",[13] as the S&P 500 was first called when it introduced its first stock index in 1923, began tracking a small number of stocks. Three years later in 1926, the Composite Index expanded to 90 stocks and then in 1957 it expanded to its current 500.[13] Standard & Poor's, a company that doles out financial information and analysis, was founded in 1860 by Henry Varnum Poor. In 1941 Poor's Publishing (Henry Varnum Poor's original company) merged with Standard Statistics (founded in 1906 as the Standard Statistics Bureau) and therein assumed the name Standard and Poor's Corporation. The S&P 500 index in its present form began on March 4, 1957. Technology has allowed the index to be calculated and disseminated in real time. The S&P 500 is widely used as a measure of the general level of stock prices, as it includes both growth stocks and value stocks.

In September 1962, Ultronic Systems Corp. entered into an agreement with Standard and Poor's. Under the terms of this agreement, Ultronics computed the S&P 500 Stock Composite Index, the 425 Stock Industrial Index, the 50 Stock Utility Index, and the 25 Stock Rail Index. Throughout the market day these statistics were furnished to Standard & Poor's. In addition, Ultronics also computed and reported the 94 S&P sub-indexes.[14]

There are also articles like Business Insider that have this graphic that may be interesting: S & P changes over the years

The makeup of the S&P 500 is constantly changing notes in part:

"In most years 25 to 30 stocks in the S&P 500 are replaced," said David Blitzer, S&P's Chairman of the Index Committee. And while there are strict guidelines for what companies are added, the final decision and timing of that decision depends on what's going through the heads of a handful of people employed by Dow Jones.

  • Thanks, that makes more sense. Would love a reference on the history of market indexes (how they came to be, how they evolved, etc.) if you know one. – Olivier Lalonde Dec 19 '16 at 6:36
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would constantly fluctuate and provide an indication of how well the market is doing.

The index is there to tell if you made profit or loss by investing in the market.

Using a pure total market cap will only tell you "Did IPO activity exceed bankruptcy and privatization activity".

  • I believe that's incorrect. Aren't market caps calculated as number of shares * spot price? AFAIK, market caps fluctuate throughout the day and year regardless of IP/bankruptcy/privatization activity. – Olivier Lalonde Dec 19 '16 at 6:32

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