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What is a stock index?

Stock index definition

So, you’re looking for a stock index definition? At its simplest, it is a measurement of the value of some or all the shares in a stock market. Such an index is usually weighted, in order to reflect the relative size and importance of different stocks. Such market indices have traditionally been used to compare an investor’s performance against the market as a whole. More recently, ‘tracker’ funds have mimicked these indices.

The best-known indices – London’s FTSE 100, the Dow Jones on Wall Street, Tokyo’s Nikkei 225 – are just some of the dozens of indices compiled round the world, from Montenegro in the Balkans to China and Russia.

Where have you heard about stock indices?

As an investor, you will have found it difficult to avoid hearing about them. Stock indices are the bedrock of market commentary, the indispensable gauge of the health or otherwise of share investment at any one time. Your financial adviser will make constant reference to them, as will the financial media and guides to investment.

What you need to know about stock indices

It is no exaggeration to say that the spread of market indices played as large a part in making stock investment safer for ordinary people as did the later tide of legislation and regulation. Before Charles Dow, a US financial journalist, unveiled his first index in 1884 that measured railroad stocks, it was hard enough for professional speculators to judge the mood of the market, let alone retail investors.

In such a climate, fraud, manipulation and market abuse could flourish.

Early days and after

Come 1896, and Dow unveiled what is probably still the best known of all market indices, the Dow Jones Industrial Average.

Another well-known American index, the Standard & Poor’s 500, can be traced right back to 1860. As with the Dow, it has its origins in the sometimes-frantic investment scene that accompanied America’s breakneck industrialisation.

The construction of market indices spread round the world, notably with the appearance of the 30-share FT Index in London in 1935. But most world indices are based on the same principles. They are assembled in such a way as to represent a notional portfolio of stocks, whose performance can then be measured.

Sometimes this portfolio can comprise the whole market in question, or something close to it, such as is the case with the Wilshire 5000 Total Market Index in the US or the FTSE All-Share Index, whose members represent about 98 per cent of the capital value of all the companies on the London Stock Exchange.

Indices, from narrow to global

Sometimes, by contrast, an index can be highly specific. For example, those shares too small to qualify for London’s FTSE All-Share Index are to be found in the FTSE Fledgling Index, while the US boasts indices as specialised as the Amex Gold Miners Index, the Dow Jones Utility Average and the Goldman Sachs TI Semiconductor Index, containing stocks such as those of Motorola and Texas Instruments.

What these different types of indices have in common is that they seek to give as accurate a reading as possible of the current state of the market concerned, whether that market be small-cap stocks in Japan or an aggregation of aspects of world indices, such as the FTSE All-World Index or the MSCI World Index.

To that end, almost all world indices will be weighted and constantly refreshed to reflect changes in the market, with, typically, quarterly changes to index composition, in which some companies are promoted and others relegated.

Weighting methods

So what are the different weighting methods available for stock indices? There are two main ways to do this:

  • A price weighted index includes an equal number of shares for each security in its basket. It adds up all the constituent stock prices and divides the total by the number of constituents, adjusted for stock splits. The Dow Jones Industrial Average is an example of such an index – it’s easily calculated, but does mean that the highest priced securities leave a heavier footprint on the index.
  • A capitalization weighted index weights its securities by market value as measured by capitalization. The S&P 500 and FTSE 100 are well-known examples of a cap-weighted index. When this weighting method is used, changes in the market value of larger securities move the index’s overall path more than those of smaller ones.

Indices as performance benchmarks

The initial purpose of all types of indices– to be able to gauge which way the market is moving – has greatly expanded in the 150 years that indices have been compiled. Most obviously, the use of stock indices as benchmarks, against which to judge the performance of individual investments or of portfolio managers, has become utterly commonplace.

Thus, for example, a fund specialising in domestic UK larger companies will me “benchmarked” against the FTSE 250 Index. Should it routinely fail at least to match the performance of the FTSE 250, then questions will be asked.

In such a situation, investor disgruntlement may well be magnified by a second trend in recent decades, the use of stock indices to construct “tracker” funds whose composition mirrors precisely that of the index it is tracking.

By definition, such a fund can do no better than the index, but neither can it do any worse. To return to our portfolio that has underperformed its benchmark, the FTSE 250, investors would be entitled to ask why they were paying for more expensive active fund management that produced inferior results to the considerably less expensive tracker investment.

Searching for patterns: indices and chart analysis

If all types of indices have greatly increased the accountability of investment funds and their managers, so have they provided the base for a huge range of derivative financial products, in which the right to buy and sell this or that index is traded on futures and options exchanges, often as part of hedging strategies.

In some ways, the most elaborate use of indices is one that would have been understandable to some of the 19th Century pioneers of index construction – so-called chart or technical analysis. Here, the movements of one or more stock indices are scrutinised not merely to get a feel for the market mood, but in furtherance of the belief that both individual stocks and indices follow patterns and that, once understood, these patterns are a powerful tool for investment analysis.

To take one example, the “advance/decline line” – which tots up the number of rising shares minus the number of falling ones and compares the result with the previous reading – is used not only to take the current temperature of the market in question but also to identify likely future patterns.

Technical analysis has many adherents, going back in some form to the earliest days of stock indices, but has also many critics, to whom the chart patterns are largely illusory and no guide to the future.

Find out more about stock indices

There is a lot more in our glossary about some of the terms that you have read here. These include tracker, derivatives, futures, options and hedging.

The performances of the Dow Jones Industrial Average and the Dow Jones Transportation Average from 1900 to the present can be found here, as can the performance of the Dow Jones Utility Average from 1928 to the present and the S&P 500 Large-Cap Index from 1925.

FTSE Russell, publisher of the FTSE and Russell families of indices, talks about its business here. Wholly owned by the London Stock Exchange, it publishes a huge range of indices ranging from global real estate to indices measuring activity in Morocco, Saudi Arabia and Kenya.

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