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FOOL SCHOOL
An index is simply a method of showing how well a stock market is performing. It enables investors to see how their own performance compares against the market as a whole. This way, they can see if they are outperforming (doing better than the index) or underperforming (not doing so well). Each index consists of a number of companies. The level of the index is based on a calculation of the average of all its constituent companies' share prices. When you hear on the news that the "Footsie has risen 100 points today", this refers to one of the most widely used stock market indices in the UK - the FTSE 100. But what does a rise of 100 points actually mean? Say the index rises by 100 points from 5,000 to 5,100, or 2%. This means that the value that the stock market is placing on all the companies within the index has gone up by 2%. The price of each company is determined by the buying and selling of its shares on that day, whether it is done by big firms in the City or retail investors like us. In most indices, the calculation of the index number is made by weighting each company's share price according to their size. So the movements of the largest UK companies such as BP (LSE: BP.) and HSBC (LSE: HSBA) have a much more significant impact on the movements of the FTSE 100. At the time of writing BP accounted for about 10% of the FTSE 100 index example while HSBC, the second biggest member, accounted for about 7.5%. If the value of BP rose by 20% therefore, and all other share prices were unchanged, the FTSE 100 would rise by 2% (being 10% of 20%). Usually an index starts off at some sort of round number. For example, the FTSE 100 began life at 1,000 points back in January 1984. At the time of writing it was about 5,300, which shows the value of the top 100 companies in the UK has risen by just over five times in the last twenty years or so. One complication you should be aware of is that most indices don't include the dividends paid out by their constituent companies - they just track the increase in their share prices. Dividends make up a significant element on the returns generated by shares so you can't just look at an index to see how much the market has grown over any particular time period. Some indices do include dividends and are referred to as total return indices, however data for these indices is often not freely available. There are hundreds of different indices across the globe. As well as tracking the markets of whole countries you can also get indices that track individual industries or large geographical regions like Europe or the Far East. In the UK the main indices include: They are also indices which track smaller companies, such as the FTSE Smallcap and the FTSE Fledgling, and the AIM market. In the US major indices include the Dow Jones Industrial Average (the Dow), the S&P 500 and the Nasdaq (where most technology shares are listed). Others you may come across include the Nikkei (Japan), the Hang Seng (Hong Kong), the Dax (Germany) and the CAC 40 (France). Each index has it own rules, drawn up by the company that runs it, which specify exactly how it is calculated and when changes are made to the companies that constitute each index. For example, the FTSE 100 has a reshuffle every three months to ensure that it continues to consist of the 100 largest companies on the UK stock market. Typically two or three new entrants will enter the index each quarter. A popular stock market strategy is to buy an index tracker which automatically follows the performance of an index. You can find out more about how index trackers track the market in our ISA centre.