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What is the difference between stock market indices and averages?

Stock indexes and averages are both designed to reflect how an overall market is doing. The percentage change in these market indicators gives you a measure of the market's performance. Indexes and averages also serve as a yardstick to measure the returns generated by your stock market investments.

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 one million shares outstanding, its market value is $10 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 Toronto Stock Exchange 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 these 300 stocks in January 1975 was added together and divided by that same market value. The resulting number, 1, was then arbitrarily multiplied by 1000 to create a base level of 1000. To calculate 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 7000, we know the total market value of those stocks has increased by seven times. The Standard and Poor's 500 is a similar, widely used market value index in the U.S. It's made up of 500 stocks such as Boeing, Dell Computer and Texaco. Stock averages are different. A stock average typically represents the total combined prices - rather than the combined market value - of a group of stocks. The world's best known average is the Dow Jones Industrial Average (DJIA). Unlike an index, an average is composed of equally weighted items. Within a stock index, each stock has a relative weight based on the stock's total market value. While a stock's relative weight within an index can change every day, a stock's weight within an average is always the same. Since the TSE 300 and the S&P 500 are market value weighted, their 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 become 0.20435952. You'd use that fraction to divide the combined price of the 30 stocks. This would give you the Dow's level. The S&P 500 is viewed as a broader measure of the U.S. stock market than the DJIA. The Dow is criticized for its small number of companies, its historic focus on industrial companies and because it has no connection to market value.