The ChoosaBroker Trading Academy

2.3. Stock Market Indices

Course Description

Most investors struggle with the art and science of picking stocks. They make the cardinal mistake of basing their decisions solely on what an individual company is doing, without paying any regard to the broader macroeconomic trend.

Academic studies have repeatedly shown that stock market indices are a leading indicator of the health of an economy, making their tracking an ideal first step in any equity investment strategy. In this lesson, we will learn:

What is a Stock Market Index?

A stock market index measures the performance of a specific “basket” of stocks. It is formed by taking the stocks of a number of different companies and then clubbing them together so that they can be tracked and often traded as one single financial instrument. If the stocks in the group change in value, the index also changes in value.
Stock market indices can be broadly classified in to five different categories:
  • Global – These indices are compiled by grouping together stocks of diverse countries from different parts of the globe. For example, the MSCI World is amongst the foremost indicators of changes in the global equity market. It contains 1,653 stocks from companies around the world.
  • Regional – Regional indices are made up of stocks belonging to a specific geographical area like Asia, Europe, Middle-East etc. The EURO STOXX 50 is a blue-chip index of the 50 largest and most liquid stocks in the Euro Zone.
  • National – These are composed of stocks of large companies listed on a particular country’s biggest stock exchange. They are excellent barometers of the state of an economy, and are the most frequently quoted in financial press. For example, the FTSE 100 is an index of the 100 biggest companies listed on the London Stock Exchange.
  • Sectoral – They are specialized indices tracking the performance of stocks belonging to key sectors within an economy. The NYSE Arca Gold BUGS is a widely-followed gold index, comprising of the biggest US and Canadian gold mining companies.
  • Market Cap – Equity indices are also often constructed based on market capitalization of companies. For example, the S&P 600 is a leading US small-cap index, measuring the performance of stocks whose market capitalization ranges from $400 million to $1.80 billion.

How is a Stock Market Index Created?

Charles Dow first published the Dow Jones Industrial Average in 1896 by allocating equal weightings to the 12 biggest U.S. industrial stocks of the day based on their prices. By the 1920s, allocations based on market capitalisation were developed by the Standard Statistics Co, resulting in a 90-stock Composite Price Index, which was the predecessor of the S&P 500 Index.
Modern financial indices are constructed in three distinct ways:
  • Equal-Weighted – Each stock has equal impact on the index.
  • Price-Weighted – Higher-priced stocks have greater influence on the index.
  • Market Cap Weighted – Stocks with bigger market-cap have bigger sway on the index.
Let us look in greater detail at how each of these indices is created:
  • Equal-Weighted Index – An equal-weighted index assigns equal weights to each stock regardless of their market capitalization or economic size. Assume that a stock market has only four companies A, B, C and D. In an equally-weighted index,

Company A will have 25% Weight in the Index
Company B will have 25% Weight in the Index
Company C will have 25% Weight in the Index
Company D will have 25% Weight in the Index
The primary advantage of using this methodology is that it does not underweight underpriced stocks or overweight overpriced stocks. The concept of equal-weighting portfolios has gained greater acceptance with the emergence of several exchange-traded funds. Historical data has repeatedly shown that equal-weighted portfolios have managed to generate superior long-term returns as compared to market cap weighted baskets. The S&P 500 Equal Weight Index is the equal-weighted version of the benchmark S&P 500, with each stock allocated a fixed weight of 0.20% of the overall index at every quarterly rebalance.

  • Price-Weighted Index – In its simplest form, a price-weighted index is the arithmetic average of the prices of all the stocks constituting the index. Let us consider the example of an equity index consisting of only 3 stocks:

Stock A is priced $100,

Stock B is priced $50, and

Stock C is priced $60

Therefore, the price-weighted index value would be 100 + 50 + 60 divided by 3 (the total number of stocks), which gives us a figure of 70.

A serious bias in such types of indices is that stocks which nominally have higher price have disproportionate impact on the index movements. The Dow Jones Industrial Average and Japan’s Nikkei 225 are the most notable price-weighted stock market averages. Both use adjustment factors in their calculations to compensate for the price skew.
Market Cap-Weighted Index – Most of the world’s stock market indices are constructed using this technique. In this, the market capitalization of a company is used to decide how much of it will make up the index. As such, bigger companies carry higher weightings, while smaller components have lower weights. The primary advantage of using this method is that as companies increase or decrease in size, their weightings in the index get automatically adjusted. The S&P 500, the NASDAQ Composite, the FTSE 100 and the CAC 40 are all capitalization-weighted indices.

  • In a market cap-weighted index, the value of each stock is calculated by multiplying the current stock price with the total number of outstanding shares. The sum of the market values of all of the component stocks in the index is then divided by an arbitrary divisor to arrive at the final index value. The value of the divisor is defined when the index is first published.

Trading and Investing in Stock Market Indices

Most new traders wrongly assume that stock indices can be traded just like individual stocks. On the contrary, these indices are created with the primary objective of providing a gauge of the performance of a sector or an entire country’s stock market.
Investors interested in acquiring long or short positions in a stock index can do so using futures and options contracts that mimic the movements of these averages. Futures and options are derivative instruments because they are derived from the underlying equity index. They are available for most major stock market indices in the world. However, investors need to be mindful that indices don’t have expire dates; futures and options contracts do; making it imperative for traders to choose the appropriate contracts before initiating a position.
Another popular route to invest in stock market indices is through exchange traded funds (ETF). Index ETFs attempt to track an equity index as closely as possible. They have many similarities with index mutual funds. But where units of a mutual fund can be redeemed at only one price each day (the net asset value), index ETFs can be bought and sold real-time on major exchanges at prices that fluctuate throughout the day. The SPDR S&P 500, listed on the NYSE Arca Exchange, is the world’s most widely-traded index ETF.

Advantages of Investing in Stock Market Indices

The number of individual stocks available for trading vastly outnumbers the number of indices, presenting investors significantly more profit-making opportunities. Nevertheless, investing in stock market indices offers five distinct advantages:
  • Diversification of Risk – When a company goes bankrupt, its stock become worthless. Shareholders also stand to suffer a loss in case the corporation experiences a financial downturn. This risk of a financial meltdown in individual companies adversely affecting the performance of your portfolio can be greatly mitigated by instead opting to invest in a basket of stocks as represented by an index.
  • Higher Leverage – Stock index futures are highly leveraged instruments. Investors have to put in a fraction of the total contract value to initiate positions, allowing them to increase the scale of their profits. Not all stocks are available to be traded on margin.
  • Greater Liquidity – Typically, index futures are the most heavily traded instruments in any major exchange. This constant presence of buyers and sellers ensures that orders get filled immediately. Also, index futures tend to be less choppy than individual stocks as far as price movements are concerned.
  • Lower Charges – The brokerage charges levied while buying or selling stock index futures is considerable lower than those imposed when transacting individual stocks. No Index Manipulation – Since major stock indices are composed of very actively traded stocks with market capitalizations running in to billions of dollars, manipulating their price movements is beyond the realms of possibility. On the other hand, individual stocks, especially if they have sub-par market volumes, are prone to undue influence from big market operators.

Final Few Notes

There might be 1000s of publicly traded companies in your country, and it’s virtually impossible for you to focus on each one of them to get a grip of the general market mood. Stock market indices are constructed to precisely serve this purpose. By keeping track of their movements, you can get a good handle on not just the investing public’s opinion of the economy, but also individual sectors and companies.

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