Composite Index: Definition, Types, and Examples

What Is a Composite Index?

A composite index is a statistical tool that groups many different equities, securities, or indexes. It aims to show how a market or specific sector performs over time.

Key composite indexes are the Nasdaq Composite, the Dow Jones Industrial Average, and the S&P 500. There are also two main types of composite index: cap-weighted and price-weighted.

Composite indexes are used in investment strategies and economic forecasting, with their elements typically combined in a standardized way so that large amounts of data can be presented easily.

Analyzing the Purpose and Function of Composite Indexes

Composite indexes are created to conduct investment analysis, measure economic trends, and forecast market activity.

They also help track how securities' prices change compared to the overall stock market or sector. They thus provide a useful benchmark against which to measure an investor's portfolio. The goal of a well-diversified portfolio is usually to outperform the main composite indexes. Three of the most-followed indexes in the United States are the Nasdaq Composite, the Dow Jones Industrial Average (the Dow), and the Standard & Poor's 500 (S&P 500) Index.

Exploring Different Types of Composite Indexes

Nasdaq Composite

The Nasdaq Composite was first established in 1971 with only 50 companies. Today, it is an index that includes more than 3,000 individual, common equities that are listed on the Nasdaq Stock Market. The Nasdaq Composite uses a market capitalization (market cap)-weighted method to calculate its value.

Standard & Poor's 500 (S&P 500) Index

The Standard & Poor's 500 (S&P 500) Index is widely regarded as the best barometer of large U.S. equities. It contains the 500 largest U.S. publicly traded companies by market value. The S&P 500 is also a cap-weighted index. 

Dow Jones Industrial Average

The Dow Jones Industrial Average (also referred to simply as "the Dow" or "the Dow Jones") is a price-weighted composite index. When you read in the news that the "market is up," they are generally referring to the Dow.

Comparing Cap-Weighted and Price-Weighted Indexes

Unlike the Dow, which is price-weighted, the Nasdaq and the S&P 500 are cap-weighted indexes.

With cap-weighted indexes, each component's total market capitalization is proportionately used to determine the index level. In this methodology, components with a higher market capitalization will have more weight in the composite, and components with a lower market capitalization will have less weight in the composite. For a stock to arrive at a cap-weighted index's total market capitalization, the price per share of each company is multiplied by its total number of shares outstanding:

Example of a Cap-Weighted Composite Index

• Stock A: Price per share equals $25 and total shares outstanding equal 1,000,000
• Stock B: Price per share equals $50 and total shares outstanding equal 500,000
• Stock C: Price per share equals $50 and total shares outstanding equal 1,000,000

Their respective market caps would be:

• Stock A = $25 × 1,000,000 = $25,000,000
• Stock B = $50 × 500,000 = $25,000,000
• Stock C = $50 × 1,000,000 = $50,000,000

Thus, the total market capitalization of the composite would be $100,000,000. Stock A's weight would be 25%, Stock B's weight would be 25%, and Stock C's weight would be 50%. Typically, an index divisor would be used to render the index manageable for reporting purposes. In this case, the divisor would be $100,000, and the initial composite level would be equal to $100,000,000 / $100,000 = 1,000.

Example of a Price-Weighted Composite Index

In a price-weighted index, components are weighted by price, not by market capitalization or shares outstanding. Each stock influences the index in proportion to its price per share. A stock with a higher price will be given more weight than a stock with a lower price, and will thus have a greater say in the index’s performance:

• Stock A: price equals $3
• Stock B: price equals $6
• Stock C: price equals $30
• Stock D: price equals $10
• Stock E: price equals $1

The composite level would be found by adding the components, then dividing that sum by the number of components. In this case, the composite level would be $10 ($50 / 5 = $10).

The Bottom Line

A composite index is a statistical tool that groups many different equities, securities, or indexes to represent overall market or sector performance.

Composite indexes serve uses such as conducting investment analysis, measuring economic trends, forecasting market activity, and providing benchmarks for investor portfolios.

The three major composite indexes in the U.S. are the Nasdaq Composite, the Dow Jones Industrial Average, and the S&P 500, all of which have significance in the nation's financial market.

Cap-weighted indexes (such as the Nasdaq Composite and the S&P 500) assign greater weight to stocks with a higher market cap, while price-weighted indexes (like the Dow) put more weight on higher-priced stocks. Each type affects not only the weight but also the influence of individual stocks in the index.

Understanding composite indexes can aid in better-informed investment strategies (such as building a well-diversified portfolio that outperforms the Nasdaq Composite, the Dow, and the S&P 500) and provide insights into market movements.