In US stock markets alone, there are just over 8000 ticker symbols (the stock abbreviation for companies, i.e. Apple’s is AAPL) available to buy and sell. That’s a lot to keep track of, especially for an investor interested in a certain sector, such as technology. Wouldn’t it be easier if they could simply dump their money into a collection of these tech shares all at once as opposed to having to buy stocks from each company individually? Enter stock indexes.
A stock index is a collection of stocks that all have something in common, whether it’s the market they’re in, the products they sell, or their financial size. This allows investors to track their broad interests as if it were a single stock. If a stock index’s price is decreasing, that means the companies within that index are, on average, also going down and vice versa for if the stock index’s price is increasing. You’ve probably heard the following names being mentioned in news channels:
Dow Jones Industrial Average (DJIA): founded in 1885, consists of the 30 most prominent companies listed on US stock exchanges. Despite its importance as a stock index, it has been criticized for not factoring in market capitalization into their calculations, which we’ll touch upon shortly.
Standard & Poor’s 500 (S&P 500): founded in 1957, consists of the 500 largest companies listed on US stock exchanges. This index is generally considered to be the most crucial and one of the leading US economic measures, with it being used as a benchmark for the economy.
Nasdaq Composite (^IXIC): founded in 1971, this is essentially where you’ll find all the tech stocks. It stands for National Association of Securities Dealers Automated Quotations.
These are the 3 most-followed stock indices in the US, and undoubtedly among the most followed in the world. Its main competitors in that respect may be the Hang Seng Index (Hong Kong’s major index), the FTSE 100 (the UK’s major index), and the Nikkei 225 (Japan’s major index). These 6 indices are considered by investors to be the global economy’s key indicators.
Pretty neat ain’t it? These indexes transform hundreds, sometimes thousands, of different numbers into just one overarching share price. But how exactly does this happen? Well, there’s a few ways. The 2 standard options are direct and indirect calculations. The direct method is simply adding each individual share price together, hence the name “direct.”
The indirect, on the other hand, would be first averaging the share prices, then multiplying that by each stock’s average trading volume (the average number of shares of a particular company traded within a day), and finally adding all those numbers up to create the trading turnover weighted price.
What this does is weigh the stocks unequally unlike the direct calculation method. Indirectly calculating allows for stocks with more trading activity to have more influence on the index’s price. But this is just one form of index weighting. The most typical one is actually based on market cap - called capitalization-weighted index - where bigger companies have greater influence, as is the case in the S&P 500 and Nasdaq; a given company’s market cap is divided by the index’s total market cap, and that result is the percent influence that the company will have on the index’s price. There’s also price-weighted indexes, where higher-priced stocks have the greater impact. This is what the Dow Jones Industrial Average is using, and it’s partly why they’ve come under heavy criticism for not adequately representing the overall US stock market. Under price-weighted indexes, you could potentially end up in situations where firms 5 times as large as any other have less influence simply because smaller firms may have a higher share price.
The other problem is that it does not necessarily account for the effect that the number of shares has on the share price’s value. If a company’s stock drops from $100 to $65 but their stock volume doubles within that same time frame, the Dow Jones would be falling even though the stock technically increased in value.
To compensate, the DJIA uses the Dow Divisor which weights a company’s share price according to their stock split - the term used to describe an increase in the number of a company’s shares. It’s a bit tricky to concisely explain how it works, so below is a brief demonstration:
We have 3 firms - A, B, and C which have share prices of $5, $10 and $20, respectively. Their pre-split average is thus $11.67. But then B decides to execute a 2-1 stock split, doubling the number of available shares and so, ceteris paribus, their share price is now $5. However, the new divisor is the sum of the 3 new prices divided by the previous average:
From here we simply divide the sum of the post-split prices by 2.57:
And voila, our new share-volume-adjusted index price! True, the price is identical to the pre-split average we calculated (so it’s not exactly “new” then), but the divisor was adjusted in accordance with the new stock prices. Even this, however, has its shortcomings. As we explained in our stock market article, a drop in share price doesn’t necessarily follow a stock split. So say company B’s post-split price is $15:
But if we calculate the post-split price the good ‘ol fashioned way:
So what just happened there? The Dow calculation may be undervaluing the index price, since calculating it the old fashioned way gives us a higher number.
To avoid all this drama, some choose to go with an unweighted index. This means that all stocks have an equal impact on the index’s price, as the change in price is based on the percent return of each company, with one of most well-known examples being the S&P 500 Equal Weight Index. Going back to our creatively-named companies, if A goes up 30%, B goes up 7%, and C goes up 0.35%, the total index would go up 12.45% - the percent changes’ average.
We’re going to conclude this article by clarifying a common misconception that gets people easily confused when trying to understand finance: a stock index is not the same as a stock exchange. Think of it this way: indexes are baskets of eggs, whereas exchanges are egg shops. Indexes are collections of stocks, exchanges are places people go to buy and sell shares. The reason people conflate the 2 is because some people thought it would be an intelligent idea to name some exchanges and indexes after one another.
There’s the Nasdaq Stock Market, for example, located in New York City and is ranked second in terms of the market cap of shares traded on an exchange (the New York Stock Exchange is first). The index we were talking about earlier is the Nasdaq Composite. In fact, the only real connection between the 2 is that the Nasdaq Composite includes almost all stocks listed on the Nasdaq Stock Market. The bottom line is this (repeat after me): indexes are not exchanges.
Econ IRL
One thing that makes the education market unique is how it exists in both public and private spheres. You have government-provided public education and business-provided private education. The activities of the former, however, almost always have greater influence on that of the latter’s, as illustrated in this week’s paper.
In November 2006, the NYC Department of Education announced the Fair Student Funding reform which would provide the city’s school districts with an additional $3.2 billion in funding starting in 2007. The researchers were curious as to whether the supply of private schools would be affected and if so, by how much exactly. They found that for every additional $1000 a public school received, the number of local private schools fell by, on average, 0.2 over the course of the 6 years following the reform.
On the other hand, a public elementary or middle school’s enrollment increased by 32 students for every $1k in funding. Although this increase was obviously mostly driven by the expanded funds public schools now had access to, the researchers wanted to see what percentage of that increase in students could be attributed to the decline of private schools. They developed their own model for doing so and estimate that 20% of the increase was because of decreased private school entry.
‘Till next time,
SoBasically