Characteristics of a Good Stock Index

by Walter Johnson

A stock index is a means of digesting and abbreviating a large stock market by focusing on a representative sample. Generally, an index is a specialized grouping of stocks in a specific sector, country, specialization or size. An investor, armed with index numbers, can keep track of an entire market without having to go through all the prices and movements, which would take a huge amount of time. At a glance, an index gives the major trends and problems within a specific sector or specialty.

Representation

Any good index must develop methods that provide more representative samples over time. The sample must, in other words, act as a micro-version of the larger market in nearly all respects. This means that within the parameters of an index, including small companies, technology companies, or utilities, the companies selected should be the most representative within that field. This requires the index to list a diverse and controlled group of companies. If, for example, the field is pharmaceuticals, the index must list its large firms, smaller specialty firms and laboratories. The more diverse the sample, the more representative the overall average becomes.

Weights

An accurate index relies upon weighting – the concept of compensating for differences in size and numbers of outstanding shares that equalize the very different price changes. A 2 percent change in a stock worth $50 is very different from a 2 percent change in a stock worth $5. Therefore, when coming up with an average, the index must compensate for these differences. Often, indexes such as the Dow Jones Industrial Average focus on market return rates, including capital gains and dividends. If the return figures are not weighted, the index may not be representative of the market as a whole.

Expertise

An index must have a staff that is expert in a specific specialty area. An index such as the Calvert Social Index, which specializes in clean energy and environmentally friendly firms, must maintain a staff that is knowledgeable and fluent in these important areas. In order to be included within the Calvert Social Index, the staff must inspect and research various firms dealing in energy and manufacturing to ensure their compliance with strict clean air and other environmental standards. This takes time and subject-area expertise that would mark indexes like these from the ordinary index model.

Independence and Transparency

Independence is a major mark of any reputable stock index. The index is a powerful tool. Seasoned investors make some of their investing decisions based on the broader implications of an indexed market trend. Therefore, if the index itself is financially involved with one of the stocks in the sector or with the sector as a whole, that is a conflict of interest. The purpose of a good index is accuracy, not special interests. One way that this has been achieved is by the public posting of methodologies and selection criteria by indexes such as the S&P 100 or the TSE 300.

About the Author

Walter Johnson has more than 20 years experience as a professional writer. After serving in the United Stated Marine Corps for several years, he received his doctorate in history from the University of Nebraska. Focused on economic topics, Johnson reads Russian and has published in journals such as “The Salisbury Review,” "The Constantian" and “The Social Justice Review."

Photo Credits

  • Hemera Technologies/AbleStock.com/Getty Images