Stock indices
Whether you own stock or not, you are probably already aware of stock market indices from reading or listening to the financial news. Stock indices are measurement tools. They are used by investors to track the market, gauge its performance and then consider the implications of its ups and downs.
You may have heard of the 'footsie' (FT 100 or the FTSE), S&P 500, Dow Jones and DAX. These are all stock indices.
Indicators of market trends
Indices present a broad picture of market trends. A stock index may help you to place the ups and downs in the price of a particular stock in the context of general market trends.
Index values
Index values are recorded continuously throughout the day. At the close of the trading day you can see the average price movement for the index compared with the previous day's closing value. Index movements are recorded in points. A rise in an index indicates that the stock market has generally performed well on that particular day, while a fall indicates the opposite.
Movements in indices over time act as a kind of economic barometer. A rise is usually a sign of good economic health for a country, whereas a drop over time signifies an economic downturn.
The calculation of indices
Most indices are weighted. This means that larger companies, as defined by market capitalisation have a greater impact on the value of the index. The averaging methods used to calculate the value of indices can differ. Arithmetic averaging involves simply adding the share prices of the component stocks and then dividing that figure by the number of stocks used. Geometric averaging is a bit more complex - the share prices of the component stocks are multiplied together and then raised to the power of 1/n, where n is the number of stocks used in the index.
Types of stock index
Not all indices are the same. Firstly, they contain different numbers of stocks. The UK FTSE-100 contains 100 stocks, while the Dow Jones Industrial Average contains only 30. The S&P 500 index in the US has 500 different stocks.
Although the number of stocks in an index remains constant, the actual stocks in the index may change. You might see a stock you have bought included in an index after a good recent performance on the market. Unfortunately, the reverse can also happen, a stock could fall out of the index, so buying a leading stock in a closely watched index is no guarantee of making money.
Markets and sectors
Indices can cover whole markets, or specific market sectors. Others are just based on stocks in particular industries, such as transportation or utilities. Indices can also record share price movements in different countries. The Nasdaq index in the US, for example, is famous for measuring the performance of domestic and foreign high-tech companies.
Choosing indices
When it comes to choosing indices, there is no one set of rules. However, you may not want just to blindly follow one index or to take one index as being representative of the market as a whole. As a general rule, the best indices cover a large number of share price movements in a wide range of sectors. A good example of this is the S&P 500, which uses 500 US companies representing the industrial, financial, utility and transportation sectors. Professional money and pension plan managers tend to use this type of index.