Why stock market indexes are based on weighted averages

Stock market indexes are central to global finance as instruments for quickly assessing the trend of a financial market. .

"The CAC 40 is weighed down by falling oil prices", "In Tokyo, the Nikkei ends up by more than 3%"... These kinds of headlines are found on a daily basis in the financial press, proof that stock market indexes are closely followed by economic players, especially traders. While the role in representing financial markets is well established, few people really understand how they work.

Here is a comprehensive summary of the information you need to understand how stock market indexes work.  

What is a stock market index?

A stock market index is a basket of securities used to assess an economy, a market, or a specific sector of economic activity. A stock market index has no intrinsic value and is therefore a calculation formula that reflects the share prices of its underlying assets. Typically, these assets are the top-rated companies on a particular stock exchange - for example, the CAC 40 reflects the top 40 French market capitalizations.   

An index can take into account different parameters in its calculation formula. These can include :

  • the volume of trading in securities on the stock exchange
  • the volume of transactions
  • capitalizations

Stock market indexes can be national or international and are useful for analysing general market trends and economic activity. Their variations, usually expressed in percentages, inform investors about the upward, stagnant or downward movements of the markets.  

How does a stock market index work ?

How stock market indexes are calculated

The main stock market indexes are actually averages, weighted or not, of the values that make them up. The results are then brought back to a constant value, expressed as points - most indexes have a base of 100 or 1,000 points.  

How are indexes weighted?

Some indexes are weighted by the value of the stocks that make them up. This is the case, for example, with the Dow Jones, which represents 30 of the largest American companies. However, this method is considered less representative of the variation in the assets that make up the index, as it gives more weight to stocks with high prices. Other indexes, such as the S&P 500, are weighted according to the market capitalization of each of the companies. This index is considered the most representative of the U.S. stock market. On the other hand, some indexes are simply not weighted, such as the Nikkei 225, the flagship index of the Tokyo Stock Exchange, which represents the 225 largest Japanese capitalizations.  

Note : the composition of stock market indexes changes constantly. It is determined by scientific committees, which generally meet one to four times a year to update the list of securities taken into account and to check their reliability and representativeness.  

Market indexes by sector

There are also indexes representing specific sectors of economic activity such as energy, banking or health, composed solely of shares of companies specialising in these areas.  

Good to know : some indexes take into account more unusual criteria, such as the companies with significant employee shareholding. This is the case of the Euronext FAS IAS index launched in 2006.  

How to invest in a market index

It’s not possible to invest directly in market indexes, which are benchmarks with no intrinsic value. However, there are  different options available for those wishing to do so :

  • CFDs, i.e financial derivatives that can have market indexes as their underlying holdings. They reproduce the evolution of the value of the indexes and thus allow speculation on the rise or fall.
  • Futures : forward contracts between two parties at a predetermined future date. Many futures contracts are based on popular market indexes.
  • ETFs : also known as index funds, these are investment portfolios that seek to replicate the performance of stock market indexes.

Market indexes are baskets of financial stocks that are representative of a specific market. Generally based on weighted averages, they are closely followed by investors who want to understand market trends. They are in themselves very popular speculation opportunities for traders.