Indices is a plural of index, unfortunately for the English language, so is indexes.  I’ll use both so you can be familiar with both terms.  I like indexes though because it’s easier to say.

We’ve talked about index funds in the mutual fund courses.  Index funds seek to mirror the return on a specific index.  The most common index fund is likely the S&P 500.  But what exactly is an index?

Generally speaking, an index in investing is a list of stocks that are meant to represent a certain market.  The S&P 500 is the 500 largest companies in the United States.  It attempts to track the overall healthiness of the stock market in the country.  The Wilshire 5000 is a total market index, much more broad than the S&P.  However Wilshire includes many small companies that do not have a large impact on the economy.  The S&P 500 is much more relevant to economic health, but the Wilshire 5000 is more relevant to the returns one may get in a diversified portfolio.

There are also indexes for small portions of the market.  Let’s say I’m an investor and think Biotechnology is about to take off.  I can follow the S&P Biotechnology Index.

Of course the most well known is the Dow Jones Industrial Average (AKA “The Dow”, “Dow 30″) which is essentially the 30 largest companies in the US.

With indexes like the S&P 500 and Dow essentially measuring the same thing, why do both exist?  An index can be weighed in many ways, the method is left to the discretion of the creator of the index.  It is then up to the media, academics, and investors to decide which indexes are the most important.  To illustrate, imagine a list of car manufacturers and their 5-year loss of value due to depreciation.

Rolls Royce        50%        $200,000
Honda                25%        $6,000
Ford                35%        $5,000

Now how many ways can you represent this list as one number?  You can average the three percentages or average the three values.  Both are viable options.  However neither would give you an accurate description of how much depreciation exists.  There may be a few thousand Rolls Royces, but there are millions of Hondas and Fords.  Once you account for this, the significance of the Rolls Royce is much less.  This is known as a weighted average.  The average of just the three as I presented them is a price weighted.  These are the most common stock indices.  Now look at how they are applied when compiling a stock index.

For illustration purposes, assume the below statements are true:

A share of Microsoft is currently $10 and the company has 12 shares outstanding, the company is worth $120.  A share of Bank of America is currently $5 and has 25 shares outstanding, the company worth $125.

Price Weighted – This is the simple way to index.  Microsoft stock is at $10 and BofA is at $5.  Their average is 7.5.

Value Weighted – Also known as capitalization weighted and market value weighted, the value weighted index takes into account the total value of a company.  Bank of America is worth more, and therefore in the value weighted index their share price is more important.  By important, I mean that a movement in the value of BofA has more impact on the value of the index.

Now let’s see how these two methods can show different pictures.  The price weighted index is 7.5 points.  The value weighted index 6.6.  This is calculated by adding the value of the stocks and dividing by the number of shares (245/37).

If BofA goes from $5 to $6, the price index moves to 8.  The same move changes the value index to 7.29.

If Microsoft instead moves $1 up, the price index is again 8.  The value index changes to 6.9.

The move in value of Bank of America is more significant from an investor return standpoint.  But the price weighted index does not account for this.  The $1 move of Bank of America moves the value weight index more than the $1 move of Microsoft.  This is how the index is self adjusting and more accurate from an investor standpoint.

So where do we see these indexes in the real world?  The Dow mentioned above is a price weighted index.  The S&P 500 is a value weighted index.

Come back tomorrow and I’ll explain why the price weighted index is completely bogus.

By The Weakonomist

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categories: business, college of weakonomics, investing