A stock market index is a number of stocks grouped together to measure a certain sector (utilities, banks, tech stocks, etc.) of the stock market.
Portfolios of individual stocks or mutual funds are often compared to a stock market index to see how well they are performing.
For example, a number of retail stocks such as Old Navy, Macy's, etc. will be grouped together to create a retail stock index. This index will then be used to track the "general" performance of the retail industry.
As the stocks in this retail group change value, the index also changes value. If the index goes up by 1% then that means the "total value" of all the securities (stocks) that make up the index have gone up in value by 1%.
If you've purchased a retail stock such as Macy's, then you would compare Macy's performance against the retail index. Ideally you would want the performance of Macy's to be better, or at least keeping pace with the index.
An index is also how people keep track of how well their investments are doing. Mutual fund managers and individual investors will find a stock market index similar to the portfolio of stocks they hold. They will then seek to meet or beat the annual percentage return of that index.
A sector index would be like the retail index example listed above. It's a specialized index tracking the performance of a specific sector of the stock market.
The Dow Jones U.S. Oil & Gas Index, for example, consists of roughly 100 companies in the oil and gas industry. The index measures the performance of the oil and gas sector of the United States equity market, including oil and gas producers, oil equipment, oil services, and distribution.
A sector index can also track companies of a certain size, a certain type of management, or even more specialized criteria.
A broad based index is exactly how it sounds, it's broad and covers a larger number of stocks. It represents the performance of a "whole market". When people refer to the stock market or its performance, they are most likely referring to a broad based index.
Three of the most regularly quoted stock market indices are the Dow Jones Industrial Average, S&P 500, and the Nasdaq Composite. These are often called "the big three". Even though there are several other broad based indices, the performance of the "big three" is viewed as a representation of the state of the U.S. economy.
The Dow Jones Industrial Average Index (commonly referred to as the Dow) is 30 of the largest and most widely held public companies in the United States. The Index includes substantial industrial companies (excluding transportation and utility companies) with a history of successful growth and wide investor interest.
Companies like General Electric, Disney, Exxon, Coca-Cola, IBM, and Microsoft are part of the Dow 30.
Wikidepdia's Definition: The Dow
The Standard & Poor 500 Index (commonly referred to as the S&P 500 or the S&P) is made up of 500 stocks from major industries of the U.S. economy. Stocks in the Index are chosen for market size (large-cap), liquidity, and industry group representation.
Companies like Wal-Mart, UPS, Starbucks, and Mastercard are part of the S&P. Since the S&P contains 500 companies most people consider the S&P a good representation of the entire U.S. stock market.
Wikidepdia's Definition: The S&P
The Nasdaq Composite Index (commonly referred to as the NASDAQ) consists of over 3000 companies. It measures all domestic and international based common stocks and similar securities listed on the Nasdaq market.
The Nasdaq Composite is heavily weighted in technology and Internet stocks, thus it is commonly referred to as the "technology index". Companies like Google, Apple, Amazon, and Research in Motion are part of the Nasdaq. However, both U.S. and non-U.S. companies are listed on the Nasdaq stock market.
Wikidepdia's Definition: The NASDAQ
With any type of investment it's important to measure the performance of that investment. Otherwise there's no way for you to distinguish between a good return on your money versus a bad one.
A relevant stock market index serves that purpose. If your investments consistently lag behind the index then you know you have a poor performer, and it may be time to find a new investment.
The yearly percent return of the index is what's used as the benchmark.
For example, let's say the value of the S&P is $10 and next year the value is $12. The index has risen in value by 20% in one year. The goal of a mutual fund manager or an individual investor is to either beat or match the 20% return.
Actually the S&P is, in my opinion, the most widely used benchmark to compare against investment performance. People are often advised to pick mutual funds or other investments that have on average beat or come close to the annual percentage returns of the S&P 500.
I've heard that only 10% of all mutual fund managers beat the S&P each year. I'm not sure if it's true, but if it is that's scary, especially since you have everyone telling you to put your money in a mutual fund.
So now you understand what a stock market index is and how it's used to gauge the performance of your investments. It's time to take action! Pull out your broker statements, then find a relevant index and see how well you are doing.