The Market Versus The Index

An “index” is a benchmark measure of the performance of a stock market, but it isn’t the “market” per se.

For example, the S&P/TSX Composite Index is an index that is widely followed to track the performance of the overall Canadian stock market. The members of the S&P/TSX Composite Index are weighted based on their market capitalization. This means that if there are 1 million shares of company XYZ in existence and the shares are trading for $10 per share, the entire company is valued at $10 million – this is known as its “market capitalization”.

By adding up all the companies’ market capitalizations we might find that the total market capitalization of the index (comprised of hundreds of companies) might be $1 billion. So on a market capitalization-weighted basis, our example company XYZ would represent 1% of the index ($10 million divided by $1 Billion). The larger the market capitalization of a company, the more weight it has in a portfolio.

Note: I’m using small, round number for the purposes of easy illustration – there are many companies that individually are worth many billions of dollars each.

At the end of 2007, there were 3,951 companies listed on the Toronto Stock Exchange, but note that the S&P/TSX Composite index only has 209 constituents. However, these 209 companies represent roughly 70% of the total market value of the Toronto Stock Exchange as many companies not listed in the index (but are part of the 3,951 constituents in the overall market) are quite small in relative value.

Related posts:

1. When A Fundamental Index Will Outperform a Market Capitalization Weighted Index
2. FTSE RAFI Methodology
3. What Qualifies As Passive Investment Management?