Stock Indices

Understanding Stock Indices 

A stock index tracks the performance of a group of stocks, offering a snapshot of one part of the market.

Indices are built around themes like large US firms (S&P 500), tech (Nasdaq Composite), or global markets (MSCI World).

They help investors gauge market trends, compare returns, and build diversified portfolios. While you can’t invest in an index directly, many funds aim to replicate its performance.

We’ll soon check on Daniel, who’s building his portfolio and learning to benchmark it against indices.

Types of Stock Indices 

Stock indices vary in construction and weighting methods.

Most modern stock indices use market-cap weighting, where companies are weighted by their total market value. The S&P 500 is a well-known example, with large firms like Nvidia and Apple having greater influence on its movement.

Price-weighted indices, like the Dow Jones Industrial Average (DJIA), assign weight based solely on share price. A $300 stock affects the DJIA more than a $30 stock, regardless of company size.

Index Rebalancing 

Indices undergo periodic rebalancing to reflect market changes, like: 

• Mergers
• Delistings
• Bankruptcies
• Shifts in company size

During rebalancing, companies may be added or removed based on criteria like market capitalization or sector classification.

This process ensures the index remains representative of its target market or sector. 

Rebalancing an index can impact stock prices. For example, stocks added to an index may see increased demand as [index funds](index funds) adjust their holdings, driving up the price.

Daniel Benchmarks  

Daniel compares his portfolio’s performance to the S&P 500 and notices a gap: the index gained 10% over the past year, while his portfolio rose just 6%.

Digging deeper, he realizes he’s overexposed to tech stocks — a sector that had surged earlier but has since cooled down.

This imbalance leaves him vulnerable to sector swings. 

Benchmarking against the S&P 500 was a wake-up call. Daniel adjusts his strategy, diversifying across industries to better reflect the broader market and reduce risk.