What is a stock market index?

What a stock market index actually is

A stock market index is a single number that summarises how a selected group of companies is performing at any given moment. Think of it as a temperature reading for a market — it tells you whether things are broadly hot or cold without making you check every company individually.

The key word is constituent: the companies that make up an index. An index does not hold any shares itself, and it is not a product you can buy directly. It is purely a measurement, calculated continuously throughout the trading day as each constituent’s share price changes.

A useful analogy: imagine your whole year group has a class average score for a test. One student having a brilliant day or a terrible one shifts that average. An index works the same way — but, as we will see, some “students” count for far more than others.

The main indices you will encounter

There are hundreds of indices around the world, but a handful appear in almost every financial news story. Here are the ones worth knowing first.

The FTSE 100

The FTSE 100 — which stands for the Financial Times Stock Exchange 100 Index — tracks the 100 largest companies listed on the London Stock Exchange, ranked by market capitalisation. It is run by FTSE Russell, a subsidiary of London Stock Exchange Group, and is recalculated in real time during trading hours.

When you hear “the market” in a UK news bulletin, the FTSE 100 is almost always what they mean. Its members include some of the most recognisable names in British business: Shell, AstraZeneca, HSBC, Unilever, BP, and Rolls-Royce.

One important caveat: the FTSE 100 is not a direct measure of the UK economy. Most of its members earn the majority of their revenue abroad. Shell sells oil and gas on global markets; AstraZeneca sells medicines worldwide. So the index can rise even when the UK domestic economy is struggling, and vice versa.

The FTSE 250

Immediately below the FTSE 100 sits the FTSE 250 — the next 250 largest UK-listed companies (ranked 101 to 350 by market cap). These tend to be more UK-focused businesses, earning more of their revenue at home. For that reason, the FTSE 250 is often considered a better barometer of the domestic UK economy than its bigger sibling.

The S&P 500 and the Dow Jones

Across the Atlantic, the two headline indices are the S&P 500 and the Dow Jones Industrial Average.

The S&P 500, managed by S&P Global, covers 500 large US companies selected by a committee. It is market-cap weighted and is widely regarded as the best single indicator of how US equities are performing. Because US companies dominate global markets, it is closely watched by investors everywhere.

The Dow Jones Industrial Average is older and narrower, covering just 30 major US companies. Unlike the S&P 500, it is price-weighted — a quirk from its 19th-century origins. This means a company with a higher share price has more influence on the Dow than one with a lower price, regardless of how large the company actually is. It is still widely reported, but most professionals regard the S&P 500 as a more representative measure.

Other global indices you will come across include Germany’s DAX (40 companies), Japan’s Nikkei 225, and France’s CAC 40 — each measuring a slice of its home country’s listed companies.

How a market-cap weighted index works

Most major indices today use market-cap weighting. A company’s market capitalisation is its share price multiplied by the number of shares it has issued. The larger a company’s total market value, the bigger its weight in the index — its share of the overall number.

In practice this means the largest companies drive most of the daily movement. If Shell represents 8% of the FTSE 100’s total value, a 5% move in Shell’s share price shifts the index far more than a 5% move in a smaller constituent representing just 0.3% of the index. The tail does not wag the dog.

This is very different from the price-weighted approach used by the Dow Jones. There, a company with a share price of £500 has five times the influence of one priced at £100, even if the £100 company is actually much larger in real-world terms. Price weighting is a legacy of the era before computers and is not used in any modern index of note.

How companies join and leave an index

FTSE Russell reviews the FTSE 100 four times a year — in March, June, September, and December. At each review, it checks whether any companies have grown large enough to join or shrunk enough to leave.

The rules use a buffer zone to prevent constant churn. A company rises into the FTSE 100 if its market cap grows enough to rank in the top 90 of all UK-listed companies. It is relegated if it falls outside the top 110. This means a company hovering just below the top 100 is not promoted and demoted every other month.

“Promotion” (from the FTSE 250 into the FTSE 100) and “relegation” are genuine market events covered in financial news — and they cause real share price moves. Index-tracking funds are forced to buy the promoted company and sell the relegated one as soon as the change takes effect. That extra demand (or supply) can push a price noticeably.

Companies can also leave an index for other reasons: being taken private, or in the most serious cases, going bust and being delisted altogether.

Why does an index go up and down?

Because an index recalculates continuously, it moves whenever any of its constituents’ prices move — which is essentially all day long during trading hours. The net result of all those individual movements, weighted by company size, is the number on the ticker.

The big drivers of daily movement include:

• Company results — when a major constituent reports earnings above or below expectations, its price reacts sharply and pulls the index in the same direction.
• Economic data — inflation figures, interest rate decisions by the Bank of England or the US Federal Reserve, and GDP readings all shape investor sentiment across the board.
• Geopolitical events — wars, elections, trade disputes, and sanctions can trigger sudden market-wide moves as investors reassess risk.
• Currency moves — for the FTSE 100, a weaker pound can actually push the index up, because overseas earnings are worth more in pounds when the pound falls. It sounds counterintuitive, but it is one of the FTSE 100’s quirks given how globally focused its members are.

It is worth remembering that not all shares move together. On most days some constituents rise and some fall; the index is the weighted net of all of them. A day when “the market fell” can still be a good day for individual shares you hold — which is precisely why comparing your portfolio against the index is so useful.

How investors use an index as a benchmark

Professional investors are judged not just on whether they made money, but on whether they made more money than the market index over the same period. This is what “beating the market” means. If the FTSE 100 returned 8% in a year and your fund returned 6%, you underperformed — even though you made a profit.

The evidence over long periods is sobering: the majority of actively managed funds fail to consistently beat their benchmark index after fees are taken into account. That finding, replicated in study after study over decades, is one of the main reasons passive investing has grown so dramatically. Rather than paying a fund manager to try and beat the market, millions of investors simply buy an ETF (exchange-traded fund) built to replicate the index return.

An index-tracking ETF holds all the constituents in the right proportions, adjusting automatically when companies join or leave. The investor gets the full market return, minus a very small fee, with no need to pick individual shares.

There is also a natural diversification benefit. Owning a slice of 100 companies means that any one company having a terrible year — an accounting scandal, a product recall, a leadership crisis — rarely destroys the whole portfolio. The 99 other constituents act as a cushion, which is one of the central ideas behind spreading money across many assets at once.

What this means for your Challenge portfolio

When you are taking part in the Student Investor Challenge, the index is your scoreboard for context. It is not enough to ask “did my portfolio go up?” — you should ask “did it go up more than the FTSE 100 over the same period?”

Here are three ways to use the index practically:

• If the FTSE 100 rose 4% and your portfolio rose 2%, you underperformed the market. That is useful feedback: it tells you to review which holdings dragged you back.
• If the FTSE 100 fell 5% and your portfolio fell only 1%, that is strong relative performance. You lost less than the market, which is exactly what a skilled investor aims for during a down period.
• The Strategic portfolio’s longer holding periods are naturally more index-like in character than the Active portfolio’s shorter moves. Over time it should track the market more closely — which is a perfectly valid strategy, as the evidence above suggests.

The FTSE 100 appears in dozens of news articles on this blog — record highs, sector rotations, earnings seasons. The index is the scoreboard that ties all of those stories together. Once you understand how it is built and what moves it, those headlines start making a great deal more sense.

FAQ

Is the FTSE 100 a reliable measure of the UK economy?

Only partly. Most FTSE 100 companies earn a large share of their revenue abroad — Shell sells oil worldwide, AstraZeneca sells medicines globally — so the index often reflects global conditions as much as UK ones. The FTSE 250, whose members tend to be more UK-focused, is often considered a better guide to the domestic economy.

What is the difference between a stock market index and a stock exchange?

A stock exchange is a marketplace where shares are bought and sold. An index is simply a measurement that tracks how a selected group of those shares is performing. The London Stock Exchange is the marketplace; the FTSE 100 is one of the tools used to measure what trades there. You could have the same exchange with dozens of different indices measuring different slices of it.

Can I buy a share of the FTSE 100?

Not directly — the index is a number, not a product. But you can invest in an ETF (exchange-traded fund) that is built to mirror the index’s performance by holding all its constituents in proportion. Index-tracking ETFs are among the most widely held investments in the world for exactly this reason.

Why does the FTSE 100 sometimes fall even when most companies have a good day?

Because market-cap weighting means the biggest companies dominate. If one or two of the very largest constituents — say, a major oil company or bank — falls sharply, they can pull the whole index down even if most of the other 98 companies had a fine day. It is one of the quirks of how market-cap-weighted indices work in practice.