Stock Market Indexes

If

we want to know how the stock

market did today, what should we
look at?

The

Dow Jones Industrial

Average?
The S&P 500 Index?
The Nasdaq Composite Index?
1

What We Need to Know to

Understand an Index
The

number of stocks in the

index.

The

types of stocks in the index.

The

weighting method used to

calculate the index value.

Price Weighting
Start by calculating the average price
(arithmetic
mean) of the stocks in the index at time
t
N

Index valuet = Pi,t divided by N

i=1

where the stocks in the index at time t go from 1 N

3

Price Weighting: An
Example
Stock
Out.
A
B

Price
Day 1
$100
$ 10

Price
Day 2
$110
$ 10

Shrs
100,000
1,000,000

Note that the market cap of each stock

is $10 million on Day 1
4

Price Weighting: An
Example

Index Value1 = (100 + 10)/2 = 55

Index Value2 = (110 + 10)/2 = 60
% Change Index = (60 - 55)/55 =
9.1%
A 10% increase in the price of stock
A caused a 9.1% increase in the
index.
5

What if Instead...
Price
Day 1

Stock
Out.
A
$100
100,000
B
$ 10
1,000,000

Price
Day 2

Shares

$100
$ 11

Example (cont.)
Index Value1 = (100 + 10)/2 = 55
Index Value2 = (100 + 11)/2 = 55.5
% Change in Index = (55.5 - 55)/55
= .91%
A 10% increase in the price of stock
B caused a 0.91% increase in the
index.
7

Stock

Price Weighting

As Price is 10 times higher so

it gets a 10 times larger weighting.

But

both companies are the same

size.

Stock

prices can be altered by

changing shares outstanding
through splits and repurchases
8

Price Weighting: Another

Example
Stock
Out
A
B

Price
Day 1

$100
$ 10

Price
Day 2

$ 55
$ 10

Shares
200,000
1,000,000

Price of Stock A goes up to $110 on day 2,

and at the close of trading, it has a 2-for-1
stock split, cutting the price in half while
doubling the shares outstanding

Price Weighting Index

Index

Value1 = (100 + 10)/2 = 55

Index

Value2 = (55 + 10)/2 = 32.5

% Change = (32.5 - 55)/55 = - 40.9%

The index is down, but stock A
gained 10% and stock B was
unchanged.
10

The Solution: Adjust the

Divisor
Adjust the Divisor so that the index
gives us the value it would have had
without the split:
Before the Split, the index would have been:
110 + 10 = 120
and 120/2 = 60
After the Split, sum of prices Day 2 = 55 +10
= 65
65/(adjusted divisor) = 60
Adjusted Divisor = 1.083333

11

The Adjusted Divisor

From

now on, we need to add the prices of the

stocks in the index and divide by the adjusted
divisor to get the index value.

We

continue to use this adjusted divisor until

another stock splits, or until one of the stocks
in the index is replaced, or if there is a spin-off
or an acquisition that alters the stocks price.

12

Price Weighting
Do

any major indexes use a Price

Weighting System?

Yes
The Dow Jones Industrial
Average does
13

DJIA: History
http://www.djindexes.com/mdsid

x/?event=showAverages
Oldest

barometer of the stock

market.
Price Weighted Index
Started in 1896 by Charles Dow
with 12 stocks. (He and Jones
started Dow Jones & Company.)
GE is the only original stock still in
the index.

14

DJIA: Composition
Today,

there are 30 Companies.

Represent

about 30% of the

market value of U.S. Stocks

27

stocks trade on the NYSE

3 stocks (MSFT, INTC, and CSCO)
trade on NASDAQ
15

DJIA: Composition
As of Jan. 1, 2010:
3M, Alcoa, American Express, AT&T,
Bank of America,Boeing, Caterpillar,
Chevron, Cisco, Coca-Cola, DuPont,
ExxonMobil, GE, Hewlett-Packard,
Home Depot, Intel, IBM, Johnson &
Johnson, JP Morgan Chase, Kraft,
McDonalds, Merk, Microsoft, Pfizer,
Procter & Gamble, Travelers, United
Technologies, Verizon, WalMart, Disney
16

DJIA: Composition
How

are the firms in the index

selected?

Editors

of the Dow Jones-owned

WSJ select the stocks.
Dow Jones is now a subsidiary of
News Corp.
17

Other Dow Jones

Price Weighted Indexes

Transportation
Utilities

(20 firms)

(15 firms)

Composite

(65 firms)

18

DJIA: Index Value

Suppose the Dow closes at
10,589.50
How did they arrive at this value?
30

Pi,t
i=1

DJIA Indext =

---------------------

Adj. Divisor
19

Market Cap Weighted

Indexes
Market Capitalization = Market
Value
DEFINITION:
#shares outstanding X Price per
Share

20

Index Value t
n

(P

i,t

) x (#Out Shrsi,t )

i=1

Indext = ----------------------------Base

Value

( Pi,b ) X (#Out shrsi,b )

i=1
21

Index Value t
t

indexes days
b is the base day
i indexes stocks
Base

day value needs to be

arbitrarily set to something by
the firm starting the index. 10 or
100 are common.
22

Back to Example: Case 1

Stock
Out.
A
B

Price
Day 1
$100
$ 10

Price
Day 2
$110
$ 10

Shares
100,000
1,000,000

Again, note that each stock has the

same market value on day 1

23

Market Value Example

Day 1
Index Value1 =

(100)(100,000) + (10)(1,000,000)
----------------------------------------- X
100
(100)(100,000) + (10)(1,000,000)
= 100
24

Market Value Example

Day 2
Index Value2 =

(110)(100,000) + (10)(1,000,000)
----------------------------------------- X
100
(100)(100,000) + (10)(1,000,000)
= 105
25

Market Value Example

% Change =
(105 - 100)/100 = 5.0%

NOTE: a10% increase in Stock A

caused a
5% increase in the index.

26

What if InsteadCase 2
Price
Stock
Day 1
Outstanding
A
$100
B
$ 10

Price
Day 2
$100
$ 11

Shares

100,000
1,000,000

Instead of stock A going up by 10%,

stock B does

27

Example (cont)
Index Value2 =
(100)(100,000) + (11)(1,000,000)
----------------------------------------- X
100
(100)(100,000) + (10)(1,000,000)
= 105
28

What if a stock splits?

Price
Day 1

Stock
Out
A
$100
200,000
B
$ 10
1,000,000

Price
Day 2

Shrs

$ 55
$ 10

Stock A goes up to $110 and then has

a 2-for-1 split at the close of Day 2
29

Market Value Example

Index Value2 =
(55)(200,000) + (10)(1,000,000)
----------------------------------------- X
100
(100)(100,000) + (10)(1,000,000)
= 105
30

Market Value Example

% Change =
(105 - 100)/100 = 5.0%
Since stocks A and B have the
same market value, they receive
the same weight in the index
What indexes use this weighting
system?
31

S&P 500

http://www2.standardandpoors.com/portal
/site/sp/en/us/page.topic/indices_500/2
,3,2,2,0,0,0,0,0,2,1,0,0,0,0,0.html
Most famous market-value weighed
index
Technically
How

a float-weighted index

many stocks are in the index?

32

S&P 500
1928

was S&P 90. In 1957 it

became S&P 500.

Is

used by 97% of U.S. money

managers and pension plan
sponsors as a proxy for the U.S.
stock market.

33

S&P 500
Stocks

are selected to include

leading companies in leading
industries in the U.S.
U.S. firms only, though some nonU.S. firms are grandfathered into
the index
Changes are made every couple of
weeks or so
Standard and Poors (a division of
McGraw-Hill) decides which
companies to include in the index
34

Other MV Weighted
Indexes
NYSE Composite: All NYSE
stocks
NASDAQ

Composite: All stocks

listed on NASDAQ (Roughly 3,000
stocks)

Wilshire

5000: All stocks traded

in the United States
35

Other MV Weighted
Indexes
Wilshire

4500: Wilshire 5000

stocks with the S&P 500 stocks
removed.

S&P

400: A mid-cap index

S&P

600: A small-cap index

36

Other MV Weighted
Indexes

Russell Indexes: U.S. Stocks from

NYSE, AMEX, and Nasdaq
http://www.russell.com/indexes
Russell 3000: 3000 largest U.S. firms
Russell 2000: 2000 smallest of Russell
3000
Russell 1000: 1000 largest of Russell
3000
37

International Indexes
International Equity Indexes:
MSCI World Index:
Maintained by Morgan Stanley
1500 stocks from 23 countries
Only companies from developed countries;
market value weighted
Global Dow: 150 stocks; both developed
and emerging countries (but 40% from
U.S.); unweighted

38

Unweighted Indexes
Each

stock receives the same

weight.

Indexes

done either with

arithmetic or geometric averages
of % changes in stock prices.

39

Back to Example: Case 1

Price
Stock
Day 1
Shares Out.
A
$100
100,000
B
$ 10
1,000,000

Price
Day 2
$110
$ 10

40

Example
Stock

A increased 10% in price

and Stock B had a price change
of 0%.

Assume

a starting index value of

100 on day 1, so Index Value1 =
100

41

Example
Using

Arithmetic Mean:
Average % Change = (10+0)/2 =
5%
Since the stocks in the index went
up by an average of 5%, the index
must go up by 5%
Index Value2 = 100 X 1.05 = 105
Used

in academic studies
42

Example
Using Geometric Mean:
Average % Change
[(1.10)(1.0)]1/2 - 1 = 4.88%
Index Value2 = 100 X 1.0488 =
104.88
Used by Value Line
43

Index Fund Formation

Price

Weighted: Equal number

of shares of each stock

Market

Value Weighted: Invest

in proportion to market
capitalization.

Unweighted:

Equal dollar
amount in each stock
44

Implications of
Skewness

Suppose there are only 4 stocks in our

world:
W, X, Y & Z

Whasa300%return
Xhasa25%return
Yhasa5%return
Zhasa-20%return

45

Implications of
Skewness
What if you invested the same amount of
money in each stock?
Portfolio

Return:
.25(300%) + .25(25%) + .25(5%) + .25(-20%)
= 77.5%

This is more than X, Y or Z, but less than W.

The outstanding performance of W drove your
results

46

Implications of
Skewness

Manyindexeshaveskewedreturns

Oftengetanarrowmarket.
Strongreturnsforanindexmaybe

primarilyduetooneortwoindustries

47

Implications of
Skewness

Foranyprice-weightedorvalue-weighted
index,asastockspricegoesup(relativeto
otherstocks)itreceivesahigherweightingin
theindex.
Thismeansthatifthereisabubbleinone
sector,theindexwilltiltmoreheavilytoward
thestocksinthatsector.
Forthosewhoinvestintheindex,itmeans
placingagreaterweightonthosestockswhich
havegoneupinpricethemost.
Isthatgoodorbad???
48