How Are Index Funds Calculated?

Index prices are the weighted average by market capitalization of their component assets.  In the case of the S&P 500, the largest 500 companies by market capitalization listed on the NYSE or Nasdaq have their market caps added up and then divided by some number so we end up with a nice number humans can visualize.  The Index funds then tracks this index giving us an investment opportunity to buy all stocks in the index at once.

What is Market Capitalization?

Market Capitalization or Market Cap is the total value of the company which is calculated by the price of the stock and how many shares there are.

\textbf{StockPrice * PricePerStock = MarketCap}

Makes sense right? If shares are ownership in a company, and if the company is made up of $5/share and there is 10 shares, then the company is worth:

\textbf{\$10 (StockPrice) * \$5 (PricePerShare) = \$50 (MarketCap)}

In the case of AAPL today, shares are worth $171.05 and there are 5.13 Billion shares:

\textbf{\$5.13B * \$171.05 = \$877.5B}

Ok, Now What’s Weighted Average?

Since Indexes are comprised of several stocks, instead of giving each company equal “weight” in the index, it is weighed depending how big the company is. Let’s say you have an index with 2 companies and Company A has a market cap of $100 and Company B has a market cap of $200, then the total market cap of the index is:

\textbf{\$100 + \$200 = \$300 MarketCap}

But since Company B is worth twice as much as Company A, then it has more weight.

\textbf{\$200 (Company B MarketCap) / \$300 (Total MarketCap) = 66.66\%}

You can think of it as a pie chart where 2/3rds of it is made up of Company B.

Buying Index Funds

Now that we have an index and we even know how it’s created, people have created funds for indexes. That means we can buy a S&P 500 index fund! The index fund basically mimics the index by holding each of the stocks in the index at the appropriate weights.  That means if the S&P500 goes up by 1% then so does the index fund. Since index funds simply track the index and can be calculated automatically, it makes the management costs on these funds much more appealing.

Basically it’s a win win! Buying indexes are generally a better investment AND it costs less than actively management funds!

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