The Dow and the Nikkei weigh their stocks by share price, a famously odd choice
Two indices quoted on the news every day, the Dow Jones Industrial Average and Japan's Nikkei 225, give more weight to companies simply because each share costs more. That means a routine stock split shrinks a company's influence even when nothing about the business has changed. How an index weighs its members matters as much as which members it picks.
A stock index tracks the performance of a market or a slice of it, letting investors compare today's prices with the past. Good indices are transparent about how they are built, and many can be bought directly through index funds; any gap between a fund's returns and its index is called tracking error. What an index covers is a separate question from how it weights its holdings. The S&P 500 covers 500 of the largest American stocks, but an equally weighted version with the same members exists too.
Coverage ranges enormously. The MSCI World holds nearly 1,400 companies across 23 developed countries, the FTSE Global Equity series reaches over 16,000, and the S&P Global 100 sticks to 100. National benchmarks such as the DAX, NIFTY 50, FTSE 100 and S&P 500 are the most quoted, and are often read as a verdict on a country's economy. Others follow single exchanges, like the NASDAQ-100, or sectors such as biotechnology.
The most common weighting is by market capitalisation, share price multiplied by shares outstanding, often adjusted to exclude stakes held by founders, governments or affiliates that rarely trade. Theory says such a portfolio offers the best expected return for its risk, and big companies can absorb large flows of money. Equal weighting gives every member the same share, which tilts towards smaller firms and tends to bring more volatility. Other schemes weight by sales or dividends, by factors such as value and momentum, a style marketed as smart beta, or by inverse volatility, so jumpy stocks count for less.
Even one index can come in several flavours. The S&P 500 exists as a price return version, a total return version that reinvests dividends, and a net total return version that reinvests them after withholding tax.
Source: Stock market index
