Investors should understand how the three major stock market indices are created. Nasdaq-100, the Dow Jones Industrial Average, and the S&P 500 are benchmarks for measuring the size of companies. The data is collected daily from publicly traded US companies. A company whose stock price is included in an index is said to be “included.”

There are two ways to build an index: a securities trader could enter all of their holdings into one basket, then calculate the final index value based on this single list of assets, or they could arrange their assets into groups that represent whole segments of investments within a company’s industry, then calculate everyone’s share of ownership for each group. The first method is known as the “value-weighted” model. The second method is known as the “volatility-weighted” model.

The S&P 500 Index and Dow Jones Industrial Average are market indexes based on the value-weighted model, while Nasdaq 100 is a market index based on a volatility-weighted formula. The value of security during the day depends on two things: how valuable it is compared to its competitors and how well it mirrors the economy at large. If a company in a particular industry didn’t pay off that day, it didn’t make sense to own that stock. Volatility-weighted indexes reflect the risk attached to different investment sectors; the S&P 500 is considered the “standard” index, reflecting generally accepted valuation.

The reason volatility-weighted indexes work best because they’re easier to balance once a company’s stock price reaches a certain level. Building an index based on market capitalization could have created wild swings while new companies and technology stocks were going up and down in value. By comparing each company’s current market cap to all of its peers, weighted by their relative growth rates and combined into one index, the volatility of each stock is significantly reduced.

There are other weighting schemes, such as the “equal-weighted” model, which could create more stable indexes. But the equal-weighted model would also increase transaction fees and is not popular. The problem with all weighting methods is that if one company’s stocks go up significantly, it will affect the index’s capitalization value almost as much as a stock with a much smaller dollar amount but with a higher percentage growth rate. Most financial analysts use equal and value weighting to build their weighted indexes.

If an investor is looking to invest in any index, it’s important to know the underlying formula used to calculate these indexes. If everyone ended up with the same index percentage, it would be a perfect reflection of all companies in the economy. Of course, that doesn’t happen. So indexes are a theoretical representation of stocks and bonds, not an exact reflection.

There are other stock indexes in addition to these three, such as the Wilshire 5000, that include thousands of publicly traded US companies from all sectors. Each year the two most important stock indexes change their members on January 1st; that’s when you need to pay attention to see if your stocks will be included.

Stocks on the Nasdaq-100 are included in the index only if they reach a certain dollar threshold. Stocks on the Dow Jones Industrial Average are included in the index by a vote of their members. The S&P 500 is the most widely used index of the three.

To understand how to get your company’s stock included in an index, you first must understand how the indexes are created. An index is a mathematical formula that estimates whether or not it would be profitable to own a basket of stocks as a reference. An investor will look at asset class diversification and add everything together, and then create one number that represents their portfolio as far as performance is concerned.

The process is easy with only 20 stocks, but it becomes much more complex when you include thousands of stocks, so weighting models are created. A weighted index either uses a value-weighted model or a volatility-weighted model. Both of these models utilize the same basic process but have different results. The value-weighted model is built by assigning a dollar amount to each stock in the index.

This dollar amount reflects the total market capitalization of each stock, multiplied by a factor to determine the weighting of each stock. A stock with $10 billion in market cap would be given a weighting ten times greater than one with $1 billion in market cap.