Making Sense Of Stock Market Indices

Stock market indices have been in existence since as early as 1884. The world's first stock market index, the Dow Jones Average, was conceived by publishers Charles H. Dow and Edward D. Jones to give investors a simple measure of the US stock market performance on any given day. Stock market indices have since evolved into important tools for investors to track the performance of various stock markets, gauge market sentiment, and assess the performance of investment managers. Investors can choose from a wide range of stock market indices, each of them capturing the performance of different stock markets, sectors or even investment themes.

What Is A Stock Market Index?

A stock market index is a portfolio of stocks constructed in such a way to give a fair representation of the performance of a given stock market, sector or investment theme. For instance, the S&P 500 Index is a stock market index that tracks the performance of the 500 largest listed companies in the US by market capitalisation, and is widely used by investors to gauge the performance of the broader US stock market. The value of a stock market index is computed on a regular basis using the market prices of the individual stocks that make up the index (also known as 'constituent stocks'), based on the calculation methodology as set out by the index provider. For the same stock market index, investors may typically encounter a price return index and a total return index. The price return index reflects only the price changes of the constituent stocks in the index, whereas the total return index reflects not only the price changes of the constituent stocks in the index, but also the reinvestment of all dividends received since the index was incepted.

Importance Of A Stock Market Index

1. Fair Representation Of Stock Market Performance: With thousands of listed companies in a stock market, it can a tedious and inefficient task to measure a stock market's performance by tracking the price changes of every publicly-traded company in that market. A stock market index overcomes this challenge as the single index value that is computed on a regular basis gives a fair representation of the performance of a given stock market, enabling investors to easily track the performance of a stock market over time.

2. Performance Benchmark: Not only does a stock market index serve as an indicator of the overall performance of a stock market, investors also use stock market indices as benchmarks to see how the performance of a security, unit trust or investment manager measures up. When investors construct their own stock portfolios, it is important to have a benchmark against which they can compare their returns, as this allows them to accurately gauge the performance of their stock portfolios. In the selection of an index as a performance benchmark, investors should also ensure that the selected index mirrors their own portfolio composition and diversity. If the performance of your portfolios has been underperforming the benchmark on a consistent basis, it may be a right time to examine your portfolio holdings and make some changes if necessary.

3. Forms The Basis Of Many Investment Products: Stock market indices also form the basis of many investment products. A stock exchange-traded fund (ETF), for instance, seeks to replicate the returns of a stock market index, either by constructing a portfolio that closely resembles the index (physical replication), or by using derivatives to track the underlying stock market index (synthetic replication). While actively managed funds seek to outperform their benchmark indices, their portfolio positions are usually relative to the benchmarks.

How Is A Stock Market Index Constructed?

The first step in the construction of a stock market index is to determine the target market or segment that the index is intended to represent. The index provider will then determine the number of stocks and the specific companies to be included in the index, based on a certain set of criteria established by the index provider, such that the resulting index and its stock constituents fairly represent the performance of the target market or segment. Each of the stock constituents in the index are also assigned a weight, which determines how much of a stock to be included in the index, using different weighting methods. Some of the most common weighting methods are price weighting and market capitalisation weighting.