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What is the significance of stock indices and averages to ordinary investors?

The rise and fall of stock indices and averages gives you a broad-brush look at what's happening in a particular market. The point or percentage change in these market indicators gives you a measure of the market's overall performance.

You can use indices and averages as a yardstick to compare the returns generated by your stock market investments. The Toronto Stock Exchange 300 Composite Index (TSE 300) is an index. The Dow Jones Industrial Average (DJIA) is an average. The picture formed from an index or average can be misleading. The reason? The index or average reflects what's happening to the group of stocks. That doesn't necessarily tell you what's happening to each individual stock in the group. A stock index represents the combined market value of all the stocks in the index. Each stock's market value is calculated by multiplying the stock's price by the number of shares outstanding. If a stock's price is $10 and it has 10 million shares outstanding, its market value is $100 million. The market value of all stocks in the particular index is added to give the total market value for the index. This total - or some fraction of it - is used to create a base value for the index. The TSE 300 is a market value index of 300 Canadian stocks that includes companies like Royal Bank, Canadian Tire and Nortel Networks. Here's how the TSE 300 index is calculated: The total market value of its 300 stocks in January 1975 was added together and divided by that same market value. The resulting number, 1, was then arbitrarily multiplied by 1,000 to create a base level of 1,000. To get the index's level today, we divide the new combined market value of the index's 300 stocks by the original total market value, which stays the same. If the index is now 10,000, we know the total market value of those stocks has increased by 10 times since January 1975. Let's assume the TSE 300 opened today at 10,000. If it ends the day at 10,050, it doesn't mean all of the 300 stocks went up. In fact, some likely would have lost value. Collectively, as a group, they were up by 50 points. Stock averages are a little different than indices. A stock average typically represents the total combined prices - rather than the combined market value - of a group of stocks. Since the TSE 300 is market value weighted, its larger weight stocks have a greater effect on the value of the index. Higher priced stocks, on the other hand, have a bigger effect on the level of averages like the DJIA. The DJIA has 30 stocks, including Coca-Cola, General Motors and Microsoft. When this average was first established in 1896, it was calculated by adding the prices of its component stocks and simply dividing by the number of stocks in the average. However, the divisor is now adjusted downwards for every stock split because of the distortions caused by stock splits (a $100 stock in a 2-for-1 split would become a $50 stock). The divisor was revised effective Nov. 1, 1999, to 0.20435952. You'd use that fraction to divide the combined price of the 30 stocks. This would give you the Dow's level. If you own an investment that does a good job of closely tracking a particular index or average, the returns you get should be pretty close to what the index produces. Index mutual funds, for example, are designed to give the results of a particular index or average. They hold all or a representative sampling of the stocks that make up the index or average.