What Is a Composite Index?
A composite index is a statistical tool that groups together many different equities, securities, or indexes in order to create a representation of overall market or sector performance. Typically, the elements of a composite index are combined in a standardized way so that large amounts of data can be presented easily.
Key Takeaways
- A composite index is a statistical tool that groups together many different equities, securities, or indexes in order to create a representation of overall market or sector performance.
- Composite indexes are used to conduct investment analyses, measure economic trends, and forecast market activity.
- The goal of a well-diversified portfolio is usually to outperform the main composite indexes—the Nasdaq Composite, the Dow, and the S&P 500.
Understanding a Composite Index
Composite indexes are created to conduct investment analysis, measure economic trends, and forecast market activity.
They are also used as tools for tracking securities' price changes relative to an entire stock market or sector. They thus provide a useful benchmark against which to measure an investor's portfolio. The goal of a well-diversified portfolio is usually to outperform the main composite indexes. Three of the most-followed indexes in the United States are the Nasdaq Composite, Dow Jones Industrial Average(the Dow), and the Standard & Poor's 500 Index (S&P 500).
Types of Composite Indexes
The Nasdaq Composite
The Nasdaq Composite was first established in 1971 with only 50 companies. Today, it is an index that includes more than 3,000 individual, common equities that are listed on the Nasdaq Stock Market. The Nasdaq Composite is calculated using a market capitalization (market cap)-weighted methodology (also referred to as a cap-weighted methodology).
Standard & Poor's 500 Index
The (S&P 500) is widely regarded as the best barometer of large U.S. equities.It contains the 500 largest, U.S. publicly-traded companies bymarket value. The S&P 500 is also a cap-weighted index.
Dow Jones Industrial Average
The Dow Jones Industrial Average (also referred to simply as "the Dow" or "the Dow Jones") is a price-weighted composite index. When you read in the news that the "market is up," they are generally referring to the Dow.
Cap-Weighted Index vs. Price-Weighted Index
Unlike the Dow (which is a price-weighted index), the Nasdaq and the S&P 500 are both cap-weighted indexes.
With cap-weighted indexes, each component's total market capitalization is proportionately used to determine the index level. In this methodology, components with a higher market capitalization will have more weight in the composite, and components with a lower market capitalization will have less weight in the composite. For a stock to arrive at a cap-weighted index's total market capitalization, the price per share of each company is multiplied by its total number of shares outstanding:
Example of a Cap-Weighted Composite Index
- Stock A: Price per share equals $25 and total shares outstanding equal 1,000,000
- Stock B: Price per share equals $50 and total shares outstanding equal 500,000
- Stock C: Price per share equals $50 and total shares outstanding equal 1,000,000
Their respective market caps would be:
- Stock A = $25 x 1,000,000 = $25,000,000
- Stock B = $50 x 500,000 = $25,000,000
- Stock C = $50 x 1,000,000 = $50,000,000
Thus, the total market capitalization of the composite would be $100,000,000. Stock A's weight would be 25%, Stock B's weight would be 25%, and Stock C's weight would be 50%. Typically, an index divisor would be used to renderthe index manageable for reporting purposes. In this case, the divisor would be $100,000, and the initial composite level would be equal to $100,000,000 / $100,000 = 1,000.
In a price-weighted index, components are weighted by price (not by market capitalization or by the number of shares outstanding). Each stock influences the index in proportion to its price per share. A stock with a higher price will be given more weight than a stock at a lower price, and therefore, that particular stock will have a greater impact on the index’s overall performance.
Example of a Price-Weighted Composite Index
In a price-weighted index, components are weighted by price, not by market capitalization or shares outstanding. Each stock influences the index in proportion to its price per share. A stock with a higher price will be given more weight than a stock with a lower price, and will thus have a greater say in the index’s performance:
- Stock A: price equals $3
- Stock B: price equals $6
- Stock C: price equals $30
- Stock D: price equals $10
- Stock E: price equals $1
The composite level would be found by adding the components, then dividing that sum by the number of components. In this case, the composite level would be $10 ($50 / 5 = $10).
