Before we can look at the specifics of indices or averages, we first need to explore the underlying financial market assets that are included in stock indices: namely stocks, shares, or equities.

Shares are a type of security defined as part ownership in a company, usually, one that is publicly listed. This gives the owner of the share an entitlement to the corporation’s earnings and assets, voting rights in major decisions about the company at the Annual General Meeting (AGM), and a dividend payment if there is one (effectively a proportion of the company’s profits).

Furthermore, if the company is run profitably and successfully, the hope is that the company’s share price will rise, and the owner of the share will make a capital gain on the value of their shareholding. Stocks and shares are primarily bought and sold on Stock Exchanges.

Averages are calculated from the prices of the selected stocks within an index (as we see below) and are used by investors as a way of gauging the performance of the different markets that the stock indices reflect. There are two main ways of calculating the value of stock indices: a price-weighted index or a capitalisation-weighted index. 

Without doing a deep dive into the mathematics behind these calculations, in simple terms they differ in this way:

• A price-weighted index uses the price of the individual stocks to determine the weighting of the stock to determine the index value. 
• A capitalisation-weighted index uses the value of the company to determine the weighting of the stock in the average. 

The Dow Jones Industrial Average is an example of a price-weighted index. The S&P 500 a capitalisation-weighted index.

Many factors can influence the level of a stock index, but the main factors are:

Data: This includes both macroeconomic and microeconomic data. 

Macroeconomic data is the major data that reflect the health of an economy or region and would include the employment, inflation and Gross Domestic Product (GDP). 

Microeconomic data is corporate data, which would include the usually quarterly release of company profits and revenues during earnings season. These data releases impact on an individual stock, and if the market moves are significant and/ or if the individual share has a significant weighting in an equity average, then it can have an impact on the overall index/ average.

Central Banks: Central Banks in most major economies control monetary policy, through changes to the national interest rate. Depending on how interest rates are expected to rise or fall in the future, this can impact on the whole economy by slowing or encouraging growth. That can affect individual shares and, by extension, the stock indices they form a part of.

Geopolitics: This is a broad concept which includes political, environmental, geographic and social impacts on economies and financial markets. Examples of geopolitics include trade wars (US-China trade war, 2018-2020), large political events (US elections, Brexit) and geographic events (also described as “Acts of God”) such as the Fukushima Daiichi nuclear disaster in 2011.