The ChoosaBroker Trading Academy

6.7. Index Composition

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 in an economy 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.

The stock market index was first devised in the late 19th century as a numerical shortcut to gauge market activity. Today, indices serve many purposes besides their original role of information compressors. In this lesson, we will learn –

INDEX COMPOSITION

From among the shares listed on a stock exchange, some similar stocks are picked and grouped together to constitute an index. This classification may be based either on the size of the company, the industry a company belongs to, the geographical location, or some other parameter. The values of the stocks grouped together are then used to calculate the value of the index. Any changes in prices of the component stocks lead to a change in the index value.

A “national” index represents the performance of the stock market of a given nation, and by extension is reflective of investor opinion of the state of the country’s economy. The most frequently quoted stock indices are national indices, made up of stocks of the biggest companies listed on the nation’s largest stock exchange, such as the American S&P 500, the British FTSE 100, and the Japanese Nikkei 225.

A “global” or “world” stock market index such as the S&P Global 100 and the MSCI World Index includes stocks from multiple regions, either grouped geographically (Asia, Europe), or by levels of income and industrialization (Emerging Markets, Developed Markets).

More specialized stock indices also exist tracking the performance of companies in specific sectors within an economy. Some examples include the S&P Financials Select Sector Index which consists of stocks in the U.S. banking and insurance space, while the Morgan Stanley Biotech Index is composed of stocks of American biotechnology firms.

HOW TO CALCULATE THE VALUE OF A STOCK MARKET INDEX

Once the stocks which are to be included in an index is carefully selected, the value of the index is most commonly calculated using any of the following two methods:

01. Price Weighted

In a price weighted index, each stock is accorded weightage on the basis of its current market price. Therefore, a stock of Company X trading at $500 per share is five times more of the total index than a stock of Company Y trading at $100 per share. As a result, any price movement in Company X’s shares will have a much bigger impact on the underlying index than a price move in Company Y’s shares. 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.

02. Capitalization Weighted

The biggest criticism directed at price weighted indices is that they don’t give any importance to the overall size of the company. The market capitalization weighted method tries to overcome this shortfall by weighing companies based on the total market value of all their shares.

In our price-weighted example, we said that Company X will have 5 times greater weightage on the index than Company Y. However, a company’s true value is not reflected merely by its share price. What if Company X is much smaller in size than Company Y? Will it then warrant the undue importance in the above cited index?

Suppose Company X has only 10,000 outstanding shares, taking its market capitalization to $5 million (share price times the amount of outstanding shares). But if Company Y has 1 million shares outstanding, its market cap would amount to $100 million. As such, under a capitalization weighted index, Company Y will be given 20 times the weight of Company X.

Capitalization weighting is the more popular index calculation methodology. Examples of such indices include the S&P 500, Germany’s DAX 30, the FTSE 100 and France’s CAC 40.

WHY DO WE NEED STOCK MARKET INDICES?

Indices are an integral part of the financial economy. Here’s why we need them:

  1. Aids in Stock Picking – In a major stock exchange, there would be thousands of companies listed. As a result, picking the appropriate stock for trading or investing may seem like a nightmare. An index provides an easy route to separate the important stocks from the rest.
  2. Reflects Investor Sentiment – Knowing investor sentiment is an essential part of the process of profitable investing. Rises and falls in an index are representative of the changing moods of the investors.
  3. Aids in Comparison – An index can be used as a benchmark against which investors can compare their portfolio’s performance.
  4. Passive Investment Tool – For investors who lack the time to actively participate in the market, investing in a basket of stocks that constitute a broad-based index is an oft utilized strategy.

FINAL THOUGHTS

By acquiring a clear understanding of how stock indices are created and how they differ from each other, you will be better positioned to make sense of the daily fluctuations in the stock market. They may seem random to the untrained eye. But beneath the noise lay broad price trends. Learning to pick them can be a good starting point to your trading journey.

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