Composite

What Is a Composite?

In the financial world, a composite is a grouping of equitiesindexes, or other investment securities in a standardized way. When applied to stock prices, a composite index can provide a useful statistical measure for the performance of the overall market, a specific sector, or an industry group. Composites are also created for investment analysis of economic trends, to forecast market activity, and as benchmarks for the relative performance of professional money managers.

Understanding Composite Indexes

A composite index can have a large number of factors that are averaged together to form a statistic representative of an overall market or sector. As an example, the Nasdaq Composite index is a market capitalization-weighted grouping of approximately 3,000 common stocks listed on the Nasdaq Stock Market. Market cap-weighted means that the index is created so that the companies with the biggest market values represent a greater proportion of the overall index.

Examples of Composite Indexes

The goal of an index is to select stocks that represent a particular sector or market, and a committee decides which stocks to include in the index. The Dow Jones 65 Composite Average is an example. The benchmark includes 65 companies that are also included in three other Dow Jones indexes: the Dow Jones Industrial Average, the Dow Jones Transportation Average, and the Dow Jones Utility Average. A committee at Dow Jones decides which stocks to include in the averages, which are constructed using a price-weighted methodology and the stocks with higher prices have more influence on the daily fluctuations in the index.

Most indexes—like the widely watched S&P 500 Index—are weighted by market capitalization rather than price. A company with a large capitalization (which is computed as shares outstanding times the current share price) makes up a larger percentage of the index’s total value and has a bigger impact on the performance of the index. Using a market capitalization approach means that companies with smaller market caps have less impact on the index.

Meanwhile, economists monitor a variety of indexes to forecast economic activity. The Index of Leading Economic Indicators, for example, is a composite of other indexes. This monthly report is composed of 10 economic indexes, including new orders for capital goods and new building permits for residential buildings. Leading indicators tend to change before movements in the overall economy.

Composite vs. Benchmark

Composite indexes are useful tools for measuring and tracking price level changes for an entire stock market, a sector, or an industry group. An index can also provide a useful benchmark against which to measure an investor’s portfolio performance. Since the goal of many professional investors is to “beat the market,” a composite can be used as a benchmark to see whether the performance of a portfolio, mutual fundor financial advisor is indeed outperforming the market as a whole.

The S&P 500 Indexfor example, is often used as a benchmark for the performance of large cap stocks. Financials sites, such as Morningstar, compare the performance of a fund to a representative benchmark and also compare the fund’s results with other funds that use the same benchmark. In addition to stocks, the financial industry also provides indexes for bonds, interest rates, commodities, and currency exchange rates.