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It is known that stock indexes and averages are statistical tools that enable investors to measure portfolios performances and sense the overall market situation. However, not everyone knows the exact difference between an index and an average. This article will give a simple explanation.
The major difference between a stock index and an average is that within a stock index each stock has a relative weight based on the stock's market capitalization whereas in an average each stock receives an equal weighting. So, a stock's weight within an index can change from day to day, but within an average it remains the same.
Let�s look at a simple example:
Consider an index named Alpha that measures the performance of the Telecom sector represented by 4 companies, a, b, c and d with market caps Ma,Mb,Mc,Md and stock prices of Pa,Pb,Pc and Pd.
The Alpha index value would be equal to:
(Pa.Ma+Pb.Mb+Pc.Mc+Pd.Md)/(Ma+Mb+Mc+Md).
Of course this fraction is then divided by a base year value for comparative purposes.
Consider now the average named Beta, that measures the same sector, and uses the same companies as reference.
Beta would typically be constructed as follows:
(Pa+Pb+Pc+Pd)/Special Divisor.
The special divisor is the result of special and complex calculation and is currently around 0.153.
In conclusion, it is important to know that stocks with higher market caps dominate the index while stocks with higher prices dominate the average.
22/07/05 Marwan Bouez