What Is a Stock Index? | How Do Stocks Work?

A stock index is a single number that tracks the combined performance of a defined group of stocks, such as the 500 large US companies in the S&P 500 or the Canadian companies in the S&P/TSX Composite. When people say “the market was up 1% today,” they usually mean an index rose 1%.

In short: an index is a set of rules. The rules decide which stocks are in it and how much each one counts. The two common weighting methods give very different results: in a market-cap-weighted index (S&P 500, Nasdaq Composite, S&P/TSX Composite), the biggest companies by total value count most. In a price-weighted index (the Dow Jones Industrial Average), the stocks with the highest share price count most, regardless of company size.

The main indexes

Index	What it covers	Weighting	Started
S&P 500	500 large US companies, chosen by a committee	Float-adjusted market cap	Launched in its 500-stock form on March 4, 1957
Dow Jones Industrial Average	30 large US “blue-chip” companies	Price	First published May 26, 1896, with 12 stocks
Nasdaq Composite	Nearly all common stocks listed on Nasdaq	Market cap	February 1971, at a base of 100
Nasdaq-100	The 100 largest non-financial companies listed on Nasdaq	Modified market cap	January 31, 1985
S&P/TSX Composite	The core of the Canadian market listed on the TSX	Float-adjusted market cap	Launched as the TSE 300 in 1977; became the S&P/TSX Composite in May 2002

The S&P 500, the Dow, and the S&P/TSX family are run by S&P Dow Jones Indices. The Nasdaq indexes are run by Nasdaq. Canada also has the S&P/TSX 60, a narrower index of 60 large companies, and the S&P/TSX Capped Composite, which limits any single company’s weight to 10%.

How stocks get in

Index rules differ:

The S&P 500 isn’t simply the 500 biggest companies. A committee selects them from US companies that meet criteria on size, liquidity, public float, and profitability (including positive reported earnings over the most recent four quarters combined and in the latest quarter). Since April 2023, companies with multiple share classes have again been eligible. More in the S&P 500 glossary entry.
The Dow is chosen by a committee too, with no fixed numerical rules: it aims to represent the US economy with 30 well-known companies.
The Nasdaq Composite includes almost everything listed on Nasdaq, which makes it heavily tilted toward technology.
The S&P/TSX Composite includes TSX-listed companies that meet minimum size, price, and trading requirements, so the number of members changes over time.

Market-cap weighting, with arithmetic

Market capitalization is share price × shares outstanding. (See the market cap entry.) In a cap-weighted index, each company’s weight is its market cap divided by the total.

Take a tiny three-company index:

Company	Price	Shares	Market cap	Weight
A	$300	100 million	$30 billion	21.43%
B	$50	2,000 million	$100 billion	71.43%
C	$20	500 million	$10 billion	7.14%
Total			$140 billion	100%

Now suppose one stock rises 10% and the others don’t move:

A rises 10% (to $330): its market cap rises $3 billion, so the total is $143 billion, up 2.14%.
B rises 10% (to $55): its market cap rises $10 billion, so the total is $150 billion, up 7.14%.

The same 10% move matters more than three times as much when it happens to the biggest company. That is the defining feature of a cap-weighted index: big companies drive it.

Turning that into an index level. The index provider picks a starting value, say 1,000, and divides total market cap by a divisor to get there. Here the divisor is $140 billion ÷ 1,000 = 0.14 billion. If B rises 10%, the index becomes $150 billion ÷ 0.14 billion = 1,071.4.

The divisor changes whenever something happens that would move the index without any change in prices, such as a company being added or removed, or new shares being issued. That keeps the index measuring price moves only.

”Float-adjusted”

The S&P 500 and S&P/TSX Composite use float-adjusted market cap: they count only shares available to public investors, excluding large blocks held by founders, governments, or other companies. A company with $100 billion of stock where 30% is held by a founding family would count as about $70 billion.

Price weighting, with arithmetic

The Dow adds up the share prices of its members and divides by a divisor. Company size plays no role.

Using the same three companies:

Sum of prices: $300 + $50 + $20 = $370. With a divisor of 3, the index is $370 ÷ 3 = 123.33.
A rises 10% ($30): sum = $400, index = 133.33, up 8.11%.
B rises 10% ($5): sum = $375, index = 125.00, up 1.35%.

The ranking has flipped. In the price-weighted version, company A, the smallest by market value but highest by share price, drives the index. Company B, which is worth more than three times as much, barely moves it.

What happens with a split

If A does a 3-for-1 split, its price drops from $300 to $100. Nothing about the company changed, but the sum of prices falls to $100 + $50 + $20 = $170. To keep the index at 123.33, the divisor is changed to $170 ÷ 123.33 = 1.3784.

After the split, A is just a $100 stock, so its influence on the index shrinks. This is why stock splits matter to the Dow but not to cap-weighted indexes. (More in stock splits and buybacks.)

The real Dow divisor has been adjusted so many times that it is well below 1, which means a $1 change in any member’s price moves the index by several points. S&P Dow Jones Indices publishes the current divisor.

Price return vs total return

The headline index levels you see quoted are usually price return indexes: they ignore dividends. Total return versions assume dividends are reinvested. Over long periods the difference is large. For example, the S&P 500 price index first closed above its 2000 high in May 2007, but on a total-return basis it had recovered earlier, because dividends kept adding up. When you compare a fund’s performance with an index, check which version is being used.

Why indexes matter

Benchmarks. Fund managers are measured against indexes. Most active managers fail to beat their benchmarks over long periods, a point covered in active vs passive investing.
Index funds and ETFs. Funds that copy an index give investors the whole basket in one purchase. How they do it is in how index funds work.
A quick read of the market. One number summarizes hundreds of price moves.

Index changes and rebalancing

Index membership changes over time. Companies are added when they grow or list, and removed when they shrink, are acquired, or no longer meet the rules. The S&P 500 is rebalanced quarterly, in March, June, September, and December, and changes are also announced between rebalances, for example when a member is taken over. The S&P/TSX Composite is also reviewed on a regular schedule by S&P Dow Jones Indices.

Because so much money tracks major indexes, an addition creates predictable buying. Suppose funds tracking an index hold $500 billion in total (an illustrative figure), and a newly added company will have a weight of 0.2%. Those funds need to own 0.2% × $500 billion = $1 billion of its shares, bought around the effective date. A deletion creates the opposite: predictable selling. Index changes are announced in advance, and traders often move prices before the change takes effect, which is one of the small, hidden costs of indexing.

Membership changes are also part of why an index holds up over long periods: it keeps dropping companies that shrank and adding companies that grew. An index is a moving list, not a fixed basket of the same companies forever.

What can go wrong

Concentration. In a cap-weighted index, a handful of very large companies can make up a big share of the total. When those few fall, the index falls, even if most members are fine. The S&P/TSX Composite has its own concentration, with financials and energy making up a large share of the Canadian market.
The index isn’t the economy. The S&P 500 holds large US-listed companies with global sales; the S&P/TSX Composite is heavy in banks and resources. Neither is a full picture of the domestic economy.
Points are not percentages. “The Dow fell 500 points” sounds dramatic, but at high index levels it can be a modest percentage move. Always look at the percentage.
You can’t buy an index directly. You buy a fund that tracks it, which has fees and small tracking differences.

The takeaway

A stock index is a rulebook for picking stocks and a formula for weighting them. Most major indexes, including the S&P 500, the Nasdaq Composite, and the S&P/TSX Composite, weight by float-adjusted market cap, so the largest companies drive them. The Dow weights by share price, a historical choice that makes high-priced stocks count most. Knowing which method an index uses tells you what its moves actually mean.