The Indices

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Attempting to understand the movements of the market as a whole is a difficult if not an impossible task. However, understanding these movements, as well as the reasons for them, is fundamental to making projections for individual stocks and grasping their performances within the parameters of their circumstances. In other words, you've got to know how the stocks have done before you can guess how they will do. Furthermore, you've got to know the conditions of the playing field before you can decide whether their earlier efforts are any indication of future performance under the same or different circumstances.

Indices, as a result of their remarkable accuracy rate, are the most accepted measurement for information about a stock's health. As an investor, you are charged with checking the performance of your stock by assembling several indications of various aspects of your stock's health, thereby creating an overall financial health picture. This overall picture is very much like a grade point average or a financial market index. Here are the indices to consult :

Dow Jones Average
NASDAQ National Market System Composite Index
Standard & Poor's 500
AMEX Market Value Index
NYSE Composite Index
Russell Indices
Wilshire 5000 Equity Index

Plain English

The indices are indicators of value changes in representative stock groupings. An index is composed of a predetermined number of stocks whose prices are combined and averaged either on the number of figures or on an earlier established benchmark.

An index compiles the prices of representative stocks to obtain an overall average of the health of the market being indexed. Think of it this way: Let's say you are the principal of a small elementary school for grades one through six. You want to discover the effectiveness of the new teaching methods you have implemented in order to determine whether or not you will continue to invest money in these initiatives. You could give every student in the school a before and an after test and then compile and compare that data. The logistics and administration of the tests could quickly become horrific though, depending on the number of students. Also, you couldn't really compare the data from grade to grade, since each grade would require a different test to correspond to the varying levels of ability.

You could, however, give the test to a sample of five students per grade. This would reduce the amount of data to 30 tests (5 samples — 6 grades = 30). You could even add the different grade-level scores together to get an overall score. By comparing the results with the same figure derived from the before-test data, you as a principal could get an overall idea of how the teaching methods had affected the quality of instruction. The advantage of this method is that only one overall score is needed and the disruption to your school is minimal.

In much the same way, indices, using just one figure or score, give a broad overview of how current events are affecting the market. An index adds up the prices of a predetermined number of stocks that are considered to best represent their markets. The sum is then averaged to provide an overall figure that is intended to represent the market as a whole.

Using the same elementary school example, by increasing the amount of data ”namely, increasing the number of students sampled ”would also provide a more accurate average. This is because by expanding the sample, the average is less affected by the changes of individual stocks. The trick, then, is to determine how much information can be handled effectively without decreasing accuracy.

Indices can measure any type of market, and anyone can create an index. Indices measure exchanges such as the New York Stock Exchange as well as industries such as utilities. Indices can also measure collective groups, such as new companies with little or substantial capitalization. The trick is to pick the stocks that best represent the market being measured. In addition, to further ensure that they remain representative, indices must be capable of incorporating adjustments based on the effects of progress and changes. For that reason, indices are active, constantly being monitored for any necessary formulaic adjustments, including the replacement of the representative stocks.

TIP

Several of these indices have achieved phenomenal popularity. The Dow is used almost synonymously with the overall market. When we say the market rose 10 points or dropped 15, what we are actually referring to is the change in the Dow index.

The good news is you don't have to do a thing. All this mathematical stuff is performed by nameless, faceless people with no friends or family. All you have to do is take the final product: a one-number answer that lets you know how "everything" is doing. In addition, chances are that an index already exists to provide an overall grade for whatever group of stocks you consider a market. Financial newsletters and the Internet make literally thousands of indices available just for the taking. Think of the indices as movie critics . Each one wants to present his or her market indicator or film critique in the hopes that you will agree it is the best description of the entirety.

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