What is a stock market index, and how is it calculated?
A number summarising the value of a defined group of shares, used as a benchmark for how a market is doing. How it is constructed matters far more than most people realise, because different construction methods produce genuinely different answers about the same market.
The main weighting methods:
Market-capitalisation weighted, the dominant approach. Each company's influence is proportional to its total market value, so the largest companies dominate. In a concentrated market a handful of companies can drive most of the index's movement, meaning "the market rose today" can mean a few giants rose while the majority fell.
Price weighted, an older method where influence depends on the share price alone. This is arbitrary — a company with a £300 share price counts for more than one with a £30 price regardless of size — and is why a small number of indices behave oddly.
Equal weighted, where every constituent counts the same. It gives a truer picture of the typical company and behaves quite differently, usually with more exposure to smaller firms.
Free-float adjusted, now standard, counting only shares actually available to trade and excluding blocks held by founders, governments or cross-holdings.
Why constituents change. Indices have rules on size, liquidity and listing, reviewed periodically. Inclusion forces index funds to buy, which is why entering or leaving a major index moves a share price independently of the business.
What an index does not tell you:
It usually excludes dividends. Headline index levels are typically price indices; the total return version, including reinvested dividends, is substantially higher over long periods. Comparing a fund's total return against a price index is an unfair comparison that flatters the fund.
It represents listed companies, not an economy. An index can be dominated by sectors and by revenues earned abroad.
Survivorship. Failed companies leave, so the index carries forward the survivors.
Why it matters practically: index funds track a specific index, so the construction rules you never read determine what you actually own.
General information, not investment advice.