What is Stock Market Index?
A stock market index is a measure of the relative value of a group of stocks in numerical terms. As the stocks within an index change value, the index value changes.
Indices are a method of measuring the value of a market segment. It is computed from the prices of selected stocks generally on the basis of weighted average.
An index is important to measure the performance of investments against a relevant market index. It is a tool used by investors and financial managers to describe the market and to compare the return on specific investments. The best known indices measure the performance of stock markets.
An index is a mathematical construct, so no investor can invest in it directly. However, there are index funds that attempt to resemble the development of indices.
Table of Contents
- 1 What is Stock Market Index?
- 2 Importance of Stock Market Indices
- 3 Computation of Index Number
- 4 Features of Index
- 5 Methodology for Index Construction
An index is used to give information about the price movements of products in the financial, commodities or any other markets. Financial indexes are constructed to measure price movements of stocks, bonds, T-bills and other forms of investments. Stock market indexes are meant to capture the overall behavior of equity markets.
A stock market index is created by selecting a group of stocks that are representative of the whole market or a specified sector or segment of the market. An index is calculated with reference to a base period and a base index value. There are three main types of indices, namely price index, quantity index and value index. The price index is most widely used. It measures changes in the levels of prices of products in the financial, commodities or any other markets from one period to another.
Stock market indexes are helpful for a variety of reasons. Some of them are:
- They provide a historical comparison of returns on money invested in the stock market against other forms of investments such as gold or debt.
- They can be used as a standard against which to compare the performance of an equity fund.
- It is a lead indicator of the performance of the overall economy or a sector of the economy
- Stock indexes reflect highly up to date information
- Modern financial applications such as Index Funds, Index Futures, Index Options play an important role in financial investments and risk management.
Importance of Stock Market Indices
Following are the importance of stock market indices:
- Indicator of Performance
- Barometer for Market Behavior
- Benchmark for Portfolio Performance
- Underlying for Other Instruments
- Supports Research
Indicator of Performance
Indices help to recognize the broad trends in the market as the lead indicator of the performance of the overall economy or a sector of the economy.
Barometer for Market Behavior
It is used to monitor and measure market movements, whether in real time, daily, or over decades, and thus helps us to understand economic conditions and future prospects. Therefore, it functions as a status report of the general economic conditions. Impacts of the various economic policies are also reflected on the stock market can be easily viewed from the performance of market indices.
Benchmark for Portfolio Performance
A managed fund can communicate its objectives and target universe by stating which index or indices serve as the standard against which its performance should be judged. Index can be used as a benchmark for evaluating the investors’ portfolio. The investor can also use the indices to allocate funds rationally among stocks. To earn returns on par with the market returns, he can choose the stocks that reflect the market movement.
Underlying for Other Instruments
Index funds and futures are formulated with the help of the indices. Usually, fund managers construct portfolios to follow any one of the major stock market index. It also underpins products such as exchange-traded funds, index funds etc. These indexes-related products form a several trillion dollar business and are used widely in investment, hedging and risk management. Example, ICICI has floated ICICI index bonds. The return of the bond is linked with the index movement.
It also supports research, risk measurement and management; and asset allocation. Like technical analysts studying the historical performance of the indices and predict the future movement of the stock market. The relationship between the individual stock and index predicts the individual share price movement.
In addition to the above functional use, a stock index reflects changing expectations of the market about the future of the corporate sector. The index rises if the market expects the future to be better than previously expected and drops if the expectation about future becomes pessimistic.
Price of a stock moves for two reasons, namely, company-specific development (product launch, closure of a factory, arrest of chief executive) and development affecting the general environment (financial crisis, election result, budget announcement), which affects the stock market as a whole.
The stock index captures the second part, that is, the impact of environmental change on the stock market as a whole. This is achieved by averaging which cancels out changes in prices of individual stocks.
Computation of Index Number
An index is a summary measure that indicates changes in value(s) of a variable or a set of variables over a time or space. It is generally computed by finding the ratio of current values(s) to a reference (base) value(s) and multiplying the resulting number by 100 or 1000.
For example, a stock market index is a number that indicates the relative level of prices or value of securities in a market on a particular day compared with a base-day price or value figure, which is usually 100 or 1000.
Example: The values of a market portfolio at the close of trading on Day 1 and Day 2 are:
|Day||Value of Portfolio||Index Value|
|1 (base day)||Rs 15,000||1000|
Assume that Day 1 is the base day and the value assigned to the base day index is 1000. On Day 2 the value of the portfolio has changed from Rs. 15,000 to Rs. 25,000, a 66.67% increase. The value of the index on Day 2 should reflect a corresponding 66.67% increase in market value.
Index on Day 2 = (Portfolio value of Day 2 *Index Value of Base day) / Portfolio Value of Base Day
Day 2’s index is 1666.67 as compared to 1000 of day 1.
The above illustration only gives out as an introduction to how an index is constructed. The daily computation of a stock index have more complexity especially when there are changes in market capitalization of constituent stocks, e.g., rights offers, stock dividend etc.
Features of Index
A good stock market index should have the following features:
Confining Behavior of Portfolios
A good market index should accurately reflect the behavior of the overall market as well as of different portfolios. This is accomplished by diversification of portfolio in such a manner that it is not susceptible to any individual stock or industry risk. A well-diversified index is more representative of the market.
However, there are diminishing returns from diversification. There is very little gain by diversifying beyond a point. Including illiquid stocks in fact worsens the index because it does not reflect the current price behavior of the market, thus its inclusion in index results in delayed or out-of-date price behavior rather than current price behavior of the market. Hence a good index should include the stocks which best represent the universe.
Including Liquid Stocks
Liquidity is much more as reflected by trading frequency. It is about ability to transact at a price, which is very close to the current market price. For example, when the market price of a stock is at Rs.320, it will be considered liquid if one can buy some shares at around Rs.320.05 and sell at around Rs.319.95. A liquid stock has very tight bid-ask spread.
An index could not remain constant. It reflects the market dynamics and hence changes are essential to maintain its representative character. This necessarily means that the same set of stocks would not satisfy index criteria at all times. A good index methodology must therefore incorporate a steady pace of change in the index set.
It is crucial that such changes are made at a steady pace. Therefore, the index set should be reviewed on a regular basis and, if required, changes should be made to ensure that it continues to reflect the current state of the market.
Methodology for Index Construction
The commonly used methods for constructing indices are:
- Price Weighted Method
- Equally Weighted Method
- Market capitalization
- Free Float Market Capitalization
Price Weighted Method
A stock index in which each stock influences the index in proportion to its price per share. The value of the index is generated by adding the prices of each of the stocks in the index and dividing them by the total number of stocks. Stocks with a higher price will be given more weight and, therefore, will have a greater influence over the performance of the index.
Therefore, it is computed by summing up the prices, of the various securities included in the index, at time 1, and dividing it by the sum of prices of the securities at time 0 multiplied by a base index value. Each stock is assigned a weight proportional to its price.
For example, Dow Jones Industrial Average and Nikkei 225.
Equally Weighted Method
An equally weighted index weights each stock equally regardless of its market capitalization or economic size (sales, earnings, book value). Due to the daily price movements of the stocks within the index, the portfolio must be constantly re-balanced to keep the positions in each stock equal to each other. The smallest companies are given equal weight to the largest companies in an equal-weight index fund or portfolio. This allows all of the companies to be considered on an even playing field.
The Rydex S&P Equal Weight Exchange Traded Fund, for example, provides the same exposure to the smallest companies in the S&P 500 as it does to corporate giants such as General Electric and Exxon.
The most commonly used weight is market capitalization (MC), that is, the number of outstanding shares multiplied by the share price at some specified time.
A type of market index whose individual components are weighted according to their market capitalization, so that larger components carry a larger percentage weighting. The value of a capitalization-weighted index can be computed by adding up the collective market capitalizations of its members and dividing it by the number of securities in the index.
The same price movement for large company will influence the value of the index more than a small company and have a dramatic effect on the value of the index. So some investors feel that this overweighting toward the larger companies gives a distorted view of the market, but the fact that the largest companies also have the largest shareholder bases makes the case for having the higher relevancy in the index.
The advantage of market capitalization-weighted indices over others is that stock splits and other capital adjustments are automatically taken care of. NASDAQ Composite, NASDAQ-100, NYSE Composite, FTSE-100, Hang Seng Index in Hong Kong, RTS Index, Russell 2000, S&P 500 – Now float-weighted, SENSEX in India are some of the examples of market capitalization weighted method.
Free Float Market Capitalization
Free-float methodology market capitalization is calculated by taking the equity’s price and multiplying it by the number of shares readily available in the market. Instead of using all of the shares outstanding like the full-market capitalization method, the free-float method excludes locked-in shares such as those held by promoters and governments.
The free-float method is seen as a better way of calculating market capitalization because it provides a more accurate reflection of market movements. When using a free-float methodology, the resulting market capitalization is smaller than what would result from a full-market capitalization method. A free-float methodology has been adopted by most of the world’s major indexes, including the Dow Jones Industrial Average and the S&P 500.
Difficulties in Index Construction
The major difficulties encountered in constructing an appropriate index are:
- Deciding the number of stocks to be included in the index
- Selecting stocks to be included in the index
- Selecting appropriate weights
- Selecting the base period and base value
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