Definition: A stock market index is an aggregation of stocks that reflect a particular economy, market, sector, commodity, or any other investments investors might want to track. Data collected from a stock market index help stakeholders to compare current price levels with price levels in the past, in order to estimate or predict future market performance.
A country’s financial system is often used as a barometer to measure the level of development of its economy. The more advanced the financial system, the more developed the economy is likely to be. One of the main components of a financial system is the stock market, a venue for the trading of stocks/equities/shares.
Content: Stock Market Index
Stock Market Index Explained
In a nutshell, a stock market index can be an indicator of the performance of a particular sector of an economy or the entire economy as a whole. A financial system is a crucial component of every economy. This is because of the important role it plays in savings and investments as well as in terms of the allocation of funds from surplus to deficit areas, among other functions.
For instance, the NASDAQ index focuses on the technology sector while the S & P 500 tries to capture all sectors of the economy. This implies that stock market indexes come in different sizes with some bigger than others. Hence, the nature of the companies that make up a stock market index can help explain the economic sector the index is focused on or indicate if it is a broad-based index that covers an entire economy.
The combination of all the stocks in an index is often referred to as the index’s “basket of stocks.” For instance, the stocks of the leading 100 companies in the US constitute the basket of stocks of the S & P 100 index. An index’s performance is, therefore, determined by the movements of its basket of stocks.
To read an index accurately requires an understanding of how the index value changes with time. A new stock market index takes off with a particular fixed value which is determined by stock prices on the take-off date. Subsequent values help to determine a rise or fall in the prices of stocks in the basket. Stock values are measured in points, for instance, “the Dow rose 70 points today.”
Though the points can represent dollars, the ratio is not 1 point: 1 dollar. In other words, the points do not exactly equate to dollars. This is because they are determined by a complex weighted average of index stocks albeit they are derived from the dollar value of underlying stocks. Thus, unlike share prices, dollars do not serve as the unit for index values and index values cannot be directly compared as is the case with share prices. This implies that a situation where the index point value of the S & P 500 is higher than the Dow index point value does not mean that the former index is performing better or is more valuable.
Also, because this take-off or starting value varies according to the stock index, it can be misleading to use points as a measure of index changes. For example, consider a couple of stock market indexes: index A and index B. If index A rises by 500 points in one day and index B rises by 20 points, the former might seem to have significantly outperformed the latter on face value. But if index A started the day at 50,000 points and index B at 500, then index B did much better in percentage terms. Note that the above instance signifies changes in collective [rather than individual] value of the baskets of stocks.
Points can also be used to show percentage increases or declines in individual stock prices. For instance, if company A loses four points, say a drop from $12 to $8, this amounts to a 33% decline in the company’s share price. But for company B with a higher stock price level, e.g., $104, a four-point loss that makes its stock price decline to $100 will only mean a 3.8% share price decline in percentage terms. One takeaway from both the collective and individual examples above is that the significance of a point change is magnified when dealing with stocks that trade at lower levels.
Stock Market Index Examples
- The S & P 500
- Dow Jones Industrial Average
- NASDAQ Composite
- NYSE AMEX Composite index
- FTSE 100
- MOEX Russia index
- Hang Seng index
- NIFTY 50
- TSEC Weighted index
- SSE Composite index, etc.
How is Stock Market Index Calculated?
As noted above, stock market indices tend to have characteristics peculiar to them. Similarly, each stock index also has its own methods of calculation. This can range from relatively simple and easy methods to very complex and confusing ones.
Below is the formula for calculating the S & P index:
Where P_i is the price of each stock in the index;
Q_i is the free-float shares; and
D is the Divisor (that normalizes index value to a digestible number).
For instance; Assuming the sum of the total value of all the stocks in the index is US$ 60 trillion and the divisor is US$ 10 billion, then the index level will be 6000.
Types of Stock Market Indices
Stock market indices are categorized as follows:
Market Capitalization Weighted Indices
- Market-Capitalization Indices: Here weights are assigned based on float-adjusted market capitalization.
- Capped Market-Capitalization Indices: The single index constituent or defined groups of index constituents [e.g., sector or geographical groups] are assigned a specific maximum weight while the excess weight is proportionately assigned to the remaining constituents of the index.
Non-Market Capitalization Weighted Indices
- Price Weighted Indices: An assignment of constituent weights is entirely based on the prices of the index’s constituent stocks. An example is the Dow Jones Industrial Average.
- Equal Weighted Indices: Here, every stock, or company in the index is assigned the same weight. Thus, a portfolio that tracks the index will invest the same dollar amount in each stock.
- Total Return Indices is the index level that reflects both stock price movements and the reinvestment of dividends.
- Leveraged and Inverse Indices follow the performance of their underlying indices with a constant multiplicative positive or negative factor, which may or may not include lending and borrowing costs.
- Weighted Return Indices is usually referred to as the index of indices. Each underlying index is assigned a weight that enables the calculation of the overall index of indices level.
- Indices Based on Index: Indices that operate on an index as a whole rather than on the individual stocks. For example, calculations of various total return methodologies and index fundamentals.
- Sector-Specific Indices: It focuses on particular sectors or segments of the market. Examples include the Philadelphia gold and silver index (XAU) whose stocks come from companies in the mining sector, the Wilshire US REIT Index which tracks over 80 real estate investment trusts, and the NASDAQ Biotechnology Index made up of nearly 200 companies in the biotech industry.
- Global Coverage Indices: It is a collection of stocks that can help measure performance on a global scale. Examples include the FTSE Global Equity Index Series and the MSCI World.
- Regional Coverage Indices: It measures stock performance for specific regions of the world. The FTSE Developed Asia Pacific Index is an example.
- Country Coverage Indices: It captures the stock performance of a particular nation and is a proxy reflection of investor perceptions on the condition of such a nation’s economy. These national indices are made up of the stocks of large firms listed on a nation’s biggest stock exchanges. Examples include the S&P 500 Index in the United States, the NIFTY 50 in India, the Nikkei 225 in Japan, and many others.
- Exchange-Based Coverage Indices: It may be based on exchange, e.g., the NASDAQ-100, or groups of exchanges, e.g., the Euronext 100.
Some other indices track companies in terms of size, type of management, or through other specialized criteria as is the case with fundamentally weighted indexes.
How do Indices Select Stocks?
There are primarily two factors that determine how stocks are selected:
In 1896, Charles Dow and Edward Jones published the Dow Jones Industrial Average index. Their index assigned weightings to the top dozen stocks based on their prices. Presently, there are also some indices in that use price to allocate weight to stocks in their basket. A good example is Japan’s Nikkei 225 where stocks with higher prices have more weight and greater impact than stocks of lower prices.
Selection based on market capitalization originated from a partnership between Henry Varnum Poor and the Standard Statistics Company which led to the establishment of the index that became the present S & P index in 1926. In this mode of selection, companies with the largest market capitalization are allocated greater weight in an index.