Wealth managers, journalists, politicians, bloggers are often comparing performances of different market indicators, but sometimes, wrong. How to avoid that?

A stock market index is basically a simple average. The value is mostly not really important, the revealing part is the extent of the change. If, for example, the index of the Mickey Mouse Stock Exchange surges one percent, that means, simplified, that the value of the stocks, a typical or near-typical portfolio on that exchange is increasing accordingly.

Donald Inc.

If we had only three stocks in the index, for example, Donald Inc., Goofy Inc., and Minnie Inc., and they were increasing one, two and three percent respectively, in this case, the average increase of this portfolio was 2 percent: (1+2+3)/3 = 2. So, the index would go up 2 percent.

But there are other methods, for example, many indexes are weighted, some are not. Larger firms – measured by the market capitalization – have more weight than a smaller one. Let’s suppose Donald Inc. has a double size than the others. In this case, it had a weight of 2, the others, 1+1. The average increase of the index would be (2x1+1x2+1x3)/4 = 7/4 = 1.75 percent.

30 giants

The value of the Dow Jones Industrial Average in the USA “is not a weighted arithmetic mean and does not represent its component companies’ market capitalization” – wrote Wikipedia. That means all 30 shares in the index are equal weighted. The S&P 500 index has different weights for each stock, depending on its respective capitalization. (Capitalization means, the value of all shares on the actual market price.)

Most modern stock market indexes contain the dividend payouts, that means, the dividends also are lifting the value of the index, not only the stock price changes. If a stock pays a dividend, but the stock price is unchanged, the value of the stock and the index surges accordingly.

One index everywhere

Some commonly used indexes aren’t containing the effect of dividends, like the Japanese Nikkei 225 or the French CAC-40. (But they have other variations containing the dividends.) Dow Jones Industrial and S&P 500, do contain it. Or, at least, this is what Wikipedia and Investopedia are suggesting.

I understand Wikipedia can be sometimes wrong, it is a user-contributed encyclopedia. But Investing.com? The latter wrote: “The Standard & Poor's 500 Index (S&P 500) is one example of a total return index.” No, it is not, at least not the version you can see on all important news sites, like Bloomberg.com, Reuters.com, Investing.com. The one with 2759.55 points last Friday.

Three versions

The most reliable source should be the fact sheet on the home page of the creator, the company S&P Dow Jones Indices, a company of S&P Global. The common version (code: SPX, 2759.55 points) is only the price index, without dividends. The total return version (SPXT) with dividends has 5479 points, the net return version (SPTR500N) 4889 points.

Because many indexes have three variations ultimately. These are the PR (price return), TR (total return or gross return) and NR (net return) indexes. The PR version doesn’t contain dividends, measures only stock price changes. The TR version contains the dividend payments and all other company events. The less used NR index contains the net dividends, after reduction of taxes.

Benefits of reinvesting

The TR indexes are like mutual funds: all cash payouts are automatically reinvested back into the portfolio itself. But be careful with any long time comparisons: individual shares, indexes or ETF's, you have to know if dividends are included or excluded in the calculations.

How much does it matter? The “normal” S&P 500 (PR) increased 9.59 percent p. a. in 10 years, the TR version 11.97. (By the fact sheet.) That seems to be not a big difference, but this 2,38 per annum is 26,52 percent in 10 years, with compound interest.

Double yield with dividends

Stock prices are on high levels in the USA, and many companies are buying back its own shares instead of paying dividends. On other stock exchanges, or in other timelines, or in greater timeframes, the difference can be larger.

For example, the French CAC-40 moves around 5063 points today, its TR version by 13 339 points. That is 163 percent more. I found data from S&P 500 PR and TR, the difference is really huge: Normal index surged 681 percent, with the dividends, that was 1341 percent. (See chart.) That means, buying shares in 1990 for 1000 USD, you would have 13 410 USD today, reinvesting the dividends. But only 6810 USD without the dividends.

Chart courtesy of StockCharts.com

Advanced indexology

There are other special cases index creators have to handle, like issuance of new stocks, withdrawal (cancellation) of any amount of a stock series, a new company in the index or total exclusion of a company. Split and reverse split of the shares, mergers, dividend payment in form of shares instead of cash etc.

The “index factories”, larger index creators are handling this cases with correction factors, like the “divisor” in the S&P 500 or Dow Jones Industrials. That has much sense because the goal of the index is measuring the changes in the value of the stock investments only. Corrections are necessary to ensure that special events or technical reasons do not alter the value of the index.

The goal (summary)

Stock indexes mostly intend to measure the value of a portfolio invested in a certain stock packet. That can be one where creators aim to represent a typical investment on a whole market, stock exchange, country. But indexes can also have a special purpose, representing for example regions, industries, small companies, large capitalization stocks, high dividend titles, low volatility stocks etc.

If you want to analyze something with indexes, you have to know what this index is created for and how it is calculated. The PR stock indexes, for example, aren’t useful if you analyze a large period because dividends are an important factor on a longer term. But for short-term comparisons, PR indexes can be also suitable.

Disclaimer:

I am not a financial advisor and this content in this article is not a financial or investment advice. It is for informative purposes only, or simply to make you think, entertain, increase testosterone and adrenaline level. Consult your advisers before making any decision.

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(Cover photo: Pixabay.com)