Stock Market Indices
What are “Stock Market Indices”?
A stock market index is a standardized metric and represents the performance of the overall stock market. It can also be reflective of investor sentiment and the state of the overall economy. A good example is the S&P 500, which is comprised of the 500 largest US stocks from across all the sectors. Two other popular stock market indices are the Dow Jones Industrial Average (DJIA) and Nasdaq Composite. There are also US indices covering smaller and more specific parts of the market. Other national stock market indices do the same in their respective countries.
In the UK, the most widely known stock market index is the FTSE 100, which includes the most highly capitalized blue-chip stocks that are listed on the London Stock Exchange (LSE). Other regularly quoted national indices are Nikkei 225 (Japan), DAX (Germany). Euro Stoxx 50 (Eurozone), CAC 40 (France) and CSI 300 Index (China). Such indices can be used as benchmarks for global financial markets and to also manage investment portfolios. Investors typically look at the change in an index, whether daily or over a particular time frame, rather than the underlying index number.
Key Learning Points
- A stock market index serves as a very useful barometer to assess market performance
- It is a single standardized metric, each with its own calculation methodology measuring the movement in a stock market
- It provides a benchmark to compare how a stock or stocks have outperformed or underperformed vis-a-vis its peers in terms of returns
- There are also global market indices (e.g. MSCI World Index or S&P Global 100 and FTSE All-World Index) and indices focusing on specific sectors and markets (g. technology, consumer goods, automotive or emerging markets)
- One can easily calculate the historical return of a stock market using the index (for example S&P 500) or the average historical return over a longer period, for example over a period of five years
- There are three main types of stock market indices – price-weighted, value (or capitalization) weighted and pure unweighted indices
- Several of the most renowned stock market indices, such as S&P 500, are market capitalization- Two excellent examples of price-weighted indices are DJIA and Nikkei 225.
Stock Market Indices – Barometer, Passive Investing and Historical Returns
Stock Market Indices serve as a very useful barometer with reference to comparing the performance of a stock vis-a-vis the market. For example, if a particular stock included in the FTSE 100 gives higher (or lower) returns than this index, it indicates that this stock has outperformed (or underperformed) it. Further, stock market indices are also very useful when it comes to passive investing (i.e. investing in a portfolio of securities that mirrors or closely resembles the index).
Suppose an investor is interested in calculating the historical return of a stock market index (S&P 500) between the period stated below, then he or she can calculate it in the following way:
Example 1: If hypothetically, the S&P 500 index was at 2,000 on December 31, 2019 and 2,300 on December 31, 2020, then the historical return for the S&P 500 as of December 31, 2020 is 15% (Historical Return = ((2300 – 2000)/2000) * 100 = 15%).
Example 2: If the investor is interested in calculating the average historical return for S&P 500 over a five year period, with historical returns being 20%, 22%, 23%, 26% and 18% as of December 31, 2016, 2017, 2018, 2019 and 2020 respectively, then the average historical return for S&P 500 over this 5 year period is: 21.8% ( Average Historical Return = (20%, + 22%, + 23%, + 26% + 18%)/5 = 21.8%).
Before an investor selects a stock market index for the purpose of investing, one should determine the composition of a particular index (stocks included, weightage accorded to various sectors in the index and how frequently is it revised) and foreign exchange risk to which that index is exposed to.
Index Weighting Types
There are three main types of stock market indices: price-weighted, value or capitalization-weighted and pure unweighted indices. In a price-weighted index, such as the DJIA, stocks with higher prices are accorded higher weights than stocks with lower prices. Consequently, these stocks with higher prices have a greater impact on the movements or changes in the index than stocks with lower prices.
In a value or capitalization-weighted index, such as the S&P 500, the weight of a particular stock in such an index is determined by multiplying the market price of this stock by the number of outstanding shares (market capitalization of that stock). In such an index, the stock with a higher market capitalization will have a greater impact on the changes or movements of such an index even if its price is lower (please refer to the workout).
The third type is an equal-weighted on unweighted index, where all stocks have an equal impact on the movement of the stock market index, irrespective of the number of shares outstanding or the price of any particular stock.
Price Weighted Index and Capitalization Weighted Index
Given below is a work out of a capitalization weighted index and a price weighted index. Several of the most renowned stock market indices, such as the S&P 500 are market capitalization-weighted. Two excellent examples of price-weighted indices are DJIA and Nikkei 225.
In the workout with reference to the capitalization-weighted index, we assume that a fictional stock market index (D&B 100) has five constituent companies. Further, the total market value of this stock market index is computed. What is notable from this workout is that Company EYE has a weighting of 48.3% in the index and the highest market capitalization. Consequently, it will have a greater impact on the movements or changes in the D&B stock market Index, even if its stock price (US$80) is lower than company ABC’s stock price (US$150).
As opposed to this, is the price weighted index (A&B 200). In this index, what matters is the price of a company’s stock. Company ZZZ has the highest weight (28.1%) in the index, as its stock price is US$18 (highest among other companies in this index). The stock of this company will have a greater impact on the movements or changes in such an index than stocks with lower prices.