A stock index is a statistic that reflects the composite value of a basket of stocks. Stocks listed within an index bear similar characteristics such as trading in the same stock exchange, belonging in the same industry or having comparable market capitalizations.
Securities based on indices, such as index funds, index futures and index options, offer investors a way to diversify their portfolio without the need to buy or sell multiple securities. The resultant benefits include less monitoring and lower transaction fees.
Indices are generally classified as either broad-based or narrow-based. Note that it is not the number of stocks that make up an index that determines whether the index is broad-based or narrow-based, but rather, the diversity of those underlying securities and the markets they cover.
A broad-base index is designed to represent the performance of the entire stock market. Its component stocks generally include some of the largest public companies from across the major industries. As such, broad-base indices are used as a guage of investor sentiment on the state of the economy.
A narrow-base index tracks the performance of stocks that have a specific characteristic, such as belonging to a particular industry or having market capitalizations within a certain range.
There are several ways in which the composite value of an index can be calculated and they affect how the index behave in response to movements of the prices of its component stocks.
In a capitalization-weighted or market value weighted index, the value of the index is calculated using the market capitalization of the component stocks and hence more weightage is given to the larger companies listed in the index.
In a price-weighted or equal dollar weighted index, the value of the index is calculated using only the price of the component stocks. Higher priced stocks are given more weightage in such indices.
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