Index vs. average: Two ways to measure the market

September 1, 2006

Here's why your stock market returns may differ from the averages you read in the paper

A. It is not surprising that your stock returns differ from the averages published in the newspaper or quoted on television and radio. Those reports focus on the movement of groups of stocks, not individual issues.

When you hear about the performance of a specific average or index, that information relates to the general direction of the market, but may not be indicative of your specific holdings. While they both measure changes in market values of certain stocks, it is important to keep in mind that there is a difference between an index and an average.

An index, on the other hand, is an average value expressed in relation to a previously determined base number. The widely publicized Standard & Poor's 500 Index (S&P 500) uses a base value of 10, which was actually determined during the period of 1941 to 1943.

An index or average may also be classified according to the method used to determine its price. In a price-weighted average index, such as the DJIA, the price of each component stock is the only consideration when determining the value of the average. The price movement of higher-priced stocks influences the average more than that of lower-priced stocks.

In contrast, a market-value weighted index, such as the S&P 500, factors in a stock's total market value, equal to the share price times the number of shares outstanding. In this type of index, a relatively small shift in the price of a large company can significantly influence the value of the index.

When comparing portfolio performance, it is important to understand the components of the various indices and averages.

Standard and Poor's 500 Index: Contains 500 "blue chip" stocks, separated by industry, so that almost all key industries are represented. Included are 400 industrial stocks, 60 transportation stocks, and 40 financial stocks (which includes banks and insurance companies).

Dow Jones Industrial Average: This commonly quoted average tracks the movement of just 30 of the largest blue chip stocks traded on the New York Stock Exchange.

NASDAQ Composite Index: Tracks the movement of all companies traded on the NASDAQ National Market System, which often tend to be smaller and more volatile stocks than those in the S&P 500 or DJIA. The NASDAQ Composite is market-value weighted, which gives a greater weighting to larger and higher-priced stocks.

NYSE Composite Index: This is the index for the trading of all New York Stock Exchange stocks. It is market-value weighted and is expressed in dollars and cents.

AMEX Composite Index: This index tracks the averages of stocks traded on the American Stock Exchange (AMEX), which tend to be medium-and smaller-sized growth stocks. The index is weighted by the market capitalization of its components. Stocks with a larger number of shares outstanding and with higher stock prices affect the index more than do smaller companies with lower prices.

Wilshire 5000 Equity Index: The broadest measure of all indices, it is market-value weighted. The Wilshire includes all major NYSE, AMEX, and NASDAQ stocks and is used as an indication of the overall direction of all stocks, regardless of size.

Europe, Australia, and Far East Index: The EAFE is an unmanaged, market-value-weighted index, designed to measure the overall condition of overseas markets.