When people talk about the share market having gone up or down, what they are usually are referring to is an index. But what is an index and why is it important?

An index measures how a certain part of the share market is performing.

Typically, each index consists of the shares that make up that part of the market. By combining these shares together, the index will give you a clearer picture of what’s happening in that part of the market.

There various types of indices on the Australian Securities Exchange (ASX), each tracking a particular investment theme such the overall market, large companies, small companies, the finance or resources sector, IT companies or a type of investment strategy.

A very important index used to measure how Australian shares are doing at any given point in time is the All Ordinaries or All Ords, which is made up of the share prices of the ASX’s 500 largest companies.

How much each share included in this index counts towards the index’s overall movement will depend on that share’s total value (the total dollar value of each company listed in the index). Large companies – such as BHP Billiton and Commonwealth Bank – are worth a lot and have heavy weights in the All Ords. As a result, they will have a bigger influence on its movement, than smaller companies.

Investors, fund managers, companies and a range of other market participants eagerly watch this index to get a feel for how the stock market is tracking.

So, for example, if there’s unsettling news somewhere in the world and the All Ords falls, watchers can get a feel of just how badly this news has hit Australian investor sentiment. If the index falls by a lot, it may suggest that investors expect this news to hurt the profits of the companies in that index.

If you invest in Australian shares, you too can use an index to compare how your own shares have been performing against the market and you can do this over different time periods, for example, the past day, week, month, year or five years.

Importantly, you can also use an index to check on how your fund manager is performing when making investments your behalf.

Most active fund managers use an index as a benchmark – that is, as a point of reference to compare their own performance. You can monitor how your fund manager performs against that index to keep track of whether or not they are worthy of the management fees you are paying. You can also determine whether other fund managers are doing a better job than your fund manager at beating that index.

Other countries have their own regularly quoted market indices. For instance, there’s the US’s S&P 500, the Japanese Nikkei 225 and the British FTSE 100. Each country will also have indices for different parts of their markets.

There’s likely to be an index to use as a benchmark for whatever asset class or group of shares you invest in. But selecting from the many investment options available can be overwhelming and complex.