It is not practical to create a portfolio of all securities for measuring, so in their place we have stock indexes that have been created to serve as indicators of the overall market performance. In addition to the general index there are specialized indexes that measure performance of specific sectors, industries, small companies, mid cap companies, parts of a stock market. Stock indexes consider only the prices of the underlying stocks and not the returns like dividends paid.

The major indexes are calculated using the "Free-float Market Capitalization" methodology, wherein, the level of index at any point of time reflects the free-float market value of the component stocks relative to a base period. The market capitalization of a company is determined by multiplying the price of its stock by the number of shares issued by the company. This market capitalization is further multiplied by the free-float factor to determine the free-float market capitalization.

Indexes are constructed from a basket of securities. For example, the S&P500 index takes the 500 biggest US companies ordered by market capitalization and then average the market capitalization of these stocks (before averaging, the market capitalization is multiplied by the free float factor). The market capitalization is simply the product of the stock price by the number of shares outstanding. The free float factor is used to include only the part of the company value that is not restricted or held by company insider.

Weightage:

All companies that are traded on the stock market are not equal. Some companies are large and some are small. The performance of a larger company will impact more than that of a smaller one. To create an equal playing field weights are assinged to stocks. The index are said to be price-weighted.

Here is a list of some weighting methods used to build indexes:

• Capitalization-weighted index: You must have an historical database of the number of shares outstanding or the market capitalization of the index stock components.
• Equal-weighted index or Price-weighted index: This type of index gives the same weight to each stock in the index or composite. Small and large companies will have the same importance in the index price.
• Volume-weighted index: This method also doesn’t need any historical database, besides the stock prices database. Stocks are weighted by the traded volume. This could be the volume of the current trading session, the recent ones or older ones.
• Fundamental-weighted index: If you have access to a fundamental database, you can create what is called a Fundamental-weighted index. These indexes weight stocks by fundamental factors like book value, revenues or sales.

The following is a list of major stock indices.

• Dow Jones Industrial Average: The Dow Jones Industrial Average is a price-weighted index of industrial stocks and the most widely quoted stock index. The Dow Jones Industrial Average uses a divisor to adjust for events that result in no change in a company's value but that would otherwise influence the index. Example a stock split. [More...]
• NASDAQ: The Nasdaq Composite Index is a market capitalization weighted index of more than 5000 stocks. It comprises all the Nasdaq-listed common stocks, and it is the most frequently used index for tracking the Nasdaq. [More...]
• Russel 2000: Russel 2000 is a market capitalized weighted index. It was created way back in 1984 by the Frank Russel Company. It covers about 3000 companies and the Russell 2000 covers the smallest two-thirds of those companies. It is basically a small cap index. [More...]
• S&P 100: S&P 100 is another very popular index. It is a market capitalization weighted index of large-cap companies. It comprises of about 100 large blue-ship companies and covers a wide range of industries.[More...]
• S&P 500 This index is used widely as a benchmark by Institutional Investors. It includes industrial, transportation, utility, and financial stocks. It is also a weighted index of large-cap companies. [More...]
• BSE Sensex: This is a Market-Capitalization-Weighted index. It comprises of 30 stocks that represent large, well-established and financiall sound companies selected across key sectors. [More...]
• NSE NIFTY: It comprises of 50 stocks which are listed on the NSE - National Stock Exchange India. Nifty is the representation of all the stocks listed in the NSE. It comprises of 50 shares. The 50 companies shares represent large, well-established and financiall sound companies selected across key sectors. [More...]
• MSCI: MSCI designs and calculates global equity indices, which, over the last 40 years, have become the most widely used global equity benchmarks by institutional investors. MSCI's global equity benchmark indices contribute to the investment process by serving as relevant performance benchmarks and effective research tools, and as the basis for various investment vehicles.

  MSCI consistently applies its index construction and maintenance methodology across developed, emerging and frontier markets. This consistent approach makes it possible to aggregate individual country and industry indices to create meaningful composite, regional, sector and industry benchmarks. Over 2,400 organizations worldwide subscribe to MSCI Equity Index products. [More...]

• FTSE: The FTSE UK Index Series is designed to represent the performance of UK companies, providing investors with a comprehensive and complementary set of indices that measure the performance of all capital and industry segments of the UK equity market. [More...]
• STOXX: The STOXX Benchmark indices cover global as well as European, Eurozone and Eastern European markets, tracking precisely the performance of broad market regions and segments. The STOXX Benchmark indices are separated into Fixed Component Benchmark indices and variable components indices. [More...]

  Worldwide, the STOXX Benchmark indices are used as underlyings for financial products and as benchmarks for actively-managed funds.

Why you should invest in Index, advantages and disadvantages of investing in them.

Indexes are a nice way to gain exposure to certain markets or sectors without having to corner the market in stocks. It’s easier to buy a commodity index instead of buying barrels of oil, some cattle, and a few bags of wheat. You can gain exposure to the overall performance of a market buy buying the appropriate index basket

While an index is designed to emulate a certain market, it doesn’t mean it’s 100% accurate. Just because you buy a foreign market index in a certain region doesn’t mean your basket will move exactly with the economy of that region. There are many factors that can alter the course of a market that sometimes an index can’t reflect, at least not immediately.

Filling a basket order is not always the easiest process either. While it is easier to buy an index than 4,000 industry stocks, that doesn’t mean you always get your target price. If you use market orders, you will eventually fill your basket, but you may not get the desired price. Or if you use limit orders, you may not get all the shares needed to fill the basket.

And not all indexes are liquid. Meaning it may be difficult to trade in and out of certain index positions. Then again, the same thing can be said for certain securities as well.