Stock Market Index Explained

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Stock market explained

The stock market is a place where traders buy and sell shares, government bonds and other assets. The stock market shows the price of shares and facilitates companies to raise revenue from issuing shares. Investors buy shares for both dividends and the prospect of capital gains. the US stock exchange based in NY (NYSE) has a market value of US $30.1 trillion as of February 2020.

How the stock market affects the global economy

Movements in share prices can have an impact on the global economy. Most famously the Wall Street Crash of 1929 was an important factor in precipitating bank closures and the great depression of the 1930s. Whilst this was the most dramatic example, movements in share prices can have an influence over the rest of the economy.

If the economy goes into recession or if there is a period of financial uncertainty then stock markets will generally fall reflecting the negative economic news.

In turn, a falling stock market can impact the economy in a negative way.

Falling share prices will:

  • Reduce consumer wealth for those who own shares. Therefore, they may spend less, leading to lower economic growth
  • Reduce the value of pension funds and reduce private pension income (if it is a prolonged fall in share prices) another factor that could cut consumer spending
  • Falling share prices make it more difficult for companies to raise finance on the stock markets, leading to lower private sector investment.
  • Falling share prices tend to reduce consumer confidence.

However in evaluation

  • Not everyone owns shares.
  • People who own shares tend to be rich and can ‘afford to lose money’ on the stock market. Therefore, their consumption levels will not be affected at all.
  • Stock market crashes don’t always affect levels of economic growth. e.g. the 1987 stock market crash didn’t reduce growth at all. (Partly because interest rates were cut sharply)

Leading stock market indexes like the FTSE-100 and Dow Jones are important in the sense that it gives an indication of the health of the biggest economies. Rising shares are a good sign, falling shares a bad sign, but in the short term, a lot of price movements can be due to speculation.

How Share Prices Affect Companies

Readers Question: A company issues stock and sells it in a primary market at a fixed price. In that case, do fluctuations in the stock market affect specific companies? In other words, when the stock value of company crashes, is that company affected at all?

If the company sells 10,000 shares at £1, then it receives £10,000 which it can use for investment. If the share price then fluctuates, it doesn’t change the initial sum the firm gained. For example, if the share price fell to 60p, the firm would still have the initial investment of £10,000. However, if the share price collapsed it would affect the company in some ways:

  • It would be harder to issue a share rights issue to raise future capital (many banks are trying to do this at the moment)
  • The firm may become subject to a takeover, especially if the collapsing share price is due to bad management and other people think they can run the company better.
  • Also, it is worth bearing in mind that a collapsing share price is often a reflection of a badly performing firm – a firm which is making a loss. It is not the other way around ie. it is not that a fall in share prices will cause a firm to become unprofitable and inefficient.

The Role of the Stock Market for Investors

Readers Question: As well, how does the stock market affect the economy? I understand the purpose it serves in raising funds for companies but not the role it plays for the investors? Anything to do with saving?

The importance of the stock market includes:

1. Raising funds for companies

Barclays recently announced a share issue to raise just under $9billion. This is to try and help the company survive the credit crunch and so it is important for the banking system, which currently needs more liquidity.

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2. A place for investment

Pension funds and investment trusts look for a variety of investment options. They will try to get a balanced portfolio to provide income and capital gains for their members. The stock market can traditionally offer a mix of interest (dividends) and capital growth over the longer term. Of course, the stock market is riskier, but, if investment trusts get it right they can offer an excellent return for their trust fund. People often forget how much dividends you can get from shares. For example, Barclays currently offer a dividend equal to 11% of the share value – making it excellent value (assuming they don’t have to write off billions of bad debt in the near future)

3. Share prices and affects on the economy

Movements in the stock market can also affect the macroeconomy in the long run through wealth and confidence effects.

Volatility of the stock market

“There is a saying: stock markets have predicted 10 out of the last 3 recessions.”

Readers Question: That does not make sense – how can you predict 10 out of 3? Did you not mean 3 out of 10?

The rationale behind the statement “stock markets have predicted 10 out of the last 3 recessions.” is that stock market volatility does not necessarily reflect economic conditions. If share prices fall 15% we may think that indicates a coming recession, but often share prices fall 15% – there is no recession, and then share prices recover.

Sometimes stock market investors panic; they think share prices are overvalued or some bad piece of economic news makes them fearful about future economic conditions. These small signals can, in some circumstances, can cause a rapid fall in share prices. The fall can then precipitate panic selling and share prices suddenly lose a large % of their value. However, later it is realised that the stock market has overreacted to a piece of bad news and actually conditions are not as dire as they feel.

Stock Market Crash of October 1987

On October 1987, stock markets around the world fell by about 25% in the space of a week. Many at the time felt this was due to an impending recession. However, economies continued to grow and the recession never materialised. Therefore, the stock market crash was not based on economic fundamentals, but, a chain of situations making people nervous and wanting to sell.

If a recession is coming, share prices will fall because a recession will mean lower profits and possibility of bankruptcy. However, just because share prices fall doesn’t mean the economy is going to do badly.

Also, I think the statement is a bit ‘tongue in cheek’ but, it is trying to emphasise the point that share price volatility is often divorced from economic reality.

What Is a Stock Market Index?

Learn how you can track the overall performance of a group of stocks over time.

What is an index?

A stock market index is a measure of a stock market, or a smaller subset of the market, that helps investors compare current price levels with past prices to calculate market performance. Investors use the calculated values of stock market indexes as an indicator of the current value of their component stocks, and they can determine returns over time by comparing current and past index levels.

Stock market indexes come in many different sizes. Some indexes have only a handful of stocks that determine their value, while others take thousands of stocks into account. You can’t invest directly in a stock market index, but by investing in index funds that allow investors to track the performance of those indexes, you can make money and profit when those indexes go up . These index funds can be structured as mutual funds or exchange-traded funds (ETFs).

Why should I follow stock market indexes?

Stock market indexes can be useful to follow for a few key reasons:

  1. Tracking the most-followed stock market indexes can give you a general sense of the health of the overall stock market.
  2. Tracking lesser-known indexes can help you see how a particular segment of the market is performing compared to the market as a whole.
  3. If you don’t want to invest in individual stocks but rather simply want to match the performance of the overall market, then a cost-effective way to earn solid returns over time is by investing in index funds that track the stock market indexes you’re most interested in.

Stock market indexes make it easier to know how the market is performing without having to follow the ups and downs of every individual stock. They also open up simple investment opportunities that even novice investors can use to participate in the long-term success of the stock market.

How should I read a stock market index?

Reading an index correctly requires that you look at how the index value changes over time. New stock market indexes always begin with a certain fixed value based on the stock prices on its starting date. Thereafter, future index values measure rising and falling prices for those component stocks.

Image source: Getty Images.

Not all stock market indexes use the same starting value, however, so just measuring index changes by using points can be misleading. For instance, if one index rises 250 points in a day while another rises just 10 points, it might seem as though the first index performed far better. However, if the first index started the day at 25,000 while the second index was at 250, then you can see that in percentage terms, the gains for the second index were far greater. A higher percentage gain means a bigger profit for you if you invest in funds that track the index, so it’s better to focus on percentages than on point movements.

Moreover, even the most popular stock market indexes don’t generally measure the performance of the entire market. Knowing which stocks are in an index can tell you which parts of the stock market are contributing to that index’s performance and can explain why other indexes might not be performing the same way.

What are the major stock market indexes?

Most investors track the performance of three key stock market indexes:

  • The Dow Jones Industrial Average (DJINDICES:^DJI) is the oldest stock market index in the U.S., dating back to the 19th century. It tracks 30 stocks that encompass a wide array of different market sectors, excluding only transportation and utility companies. The manager of the Dow tends to keep its 30 component stocks unchanged for years at a time, replacing companies only when necessary to keep up the index’s reputation of including only stocks of top-quality companies.
  • The S&P 500 (SNPINDEX:^GSPC) is a broader index that includes about 500 large-company stocks. Its component stocks get replaced much more frequently, as the index attempts to include a representative mix of companies that reflect the overall U.S. economy.
  • The Nasdaq Composite (NASDAQINDEX:^IXIC) is an index of stocks that trade on the Nasdaq Stock Market. Investors often use the Nasdaq as a gauge of the performance of the technology sector, because many of the largest and most influential components of the Nasdaq are tech stocks.

Beyond these well-known indexes, however, there are hundreds more stock market indexes. You can find indexes that reflect the performance of stocks in a certain country or that do business in a given sector of the economy. Some indexes separate large, mid-sized, and small companies into different categories. Others use investing strategies like growth, value, or dividend investing to select component stocks. Pretty much any type of stock you might be interested in, there’s an index for that. The rise of index mutual funds and ETFs has led to a proliferation of indexes to help fund managers use passive investing strategies to minimize costs and let investors tailor their portfolio exposure as precisely as they like.

How are indexes weighted?

Each component stock in an index has a weighting assigned to it. Stocks with higher weightings have more influence on the index’s movements than those with lower weightings, and there are three different ways that indexes typically assign weightings to their stocks:

  • Price-weighted indexes give more weight to companies with higher stock prices. For example, in a hypothetical index made up of three stocks with share prices of $70, $20, and $10, the $70 stock would make up 70% of the total index, regardless of the relative size of the company. The Dow Jones Industrials is the most important example of a price-weighted index.
  • Market-capitalization-weighted indexes give more weight to companies with higher market capitalizations. Both the S&P 500 and the Nasdaq Composite are market-cap weighted, and large companies like Apple and Microsoft have much greater weightings than the smaller companies that make up the indexes.
  • Equal-weight indexes simply assign the same weighting to each stock, regardless of price, market capitalization, or any other factor.

There are some other stock market indexes that use proprietary methods to come up with weightings. For example, some indexes assign weightings based on the dividends that a stock pays out. For the most part, though, market-cap-weighted indexes are most prevalent, as they’re often the easiest for index funds to track.

What is a stock market index?

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Stock market index

A stock market index is a statistical measure which shows changes taking place in the stock market. To create an index, a few similar kinds of stocks are chosen from amongst the securities already listed on the exchange and grouped together.
The criteria of stock selection could be the type of industry, market capitalisation or the size of the company. The value of the stock market index is computed using values of the underlying stocks. Any change taking place in the underlying stock prices impact the overall value of the index. If the prices of most of the underlying se.

Stock Index

What is Stock Index?

Stock index which is also known as the stock market index is a tool used to determine the performance of shares/securities in the market and to calculate the return on the stock of their investment and it is used by investors to have knowledge about the performance of investments and access the total value they possess.

Indexes are often used as a benchmark against which performances of Mutual Funds and ETF’s are compared. The stock index is further used as investment decisions before adjusting the portfolio. For e.g. a number of Mutual Funds compare their returns to the return in the S&P 500 displaying to the investors how their funds are performing in tandem with the stock index.

List of Top 5 Types of Stock Index

Below is the list of top stock indices –

#1 – Standard & Poor 500 (S&P 500)

S&P 500 is a large and diverse stock index made up of 500 of the most widely traded stocks especially in the USA. Since the USA is an epicenter of the financial activities impacting across the world, this index gives a good indication of movement in the US as a marketplace. The stock index is market-weighted (capitalization weighted), each stock is represented in proportion to its market capitalization. Thus, if the total market value of all 500 companies in the S&P 500 increases by 6%, the value of the index also increases by 6%.

Firms from various sectors are included in this index such as:

  • Financial sector
  • Healthcare
  • Industrials
  • Information Technology
  • Consumer Staples
  • Energy
  • Media

#2 – NASDAQ

It’s a stock market index of the US that measures the performance of around 3,000 companies including foreign companies. Predominantly, known for technology-based companies such as Google, Apple, and other firms in the growth stages, the NASDAQ also measures stocks from other sectors such as:

The value of NASDAQ is computed on the company’s outstanding stock i.e. market capitalization average of multiple firms part of the index. Therefore the performance of NASDAQ is directly proportional to the performance of the technology sector. There are 3 different market tiers namely:

  1. Capital market (Small-cap): An equity market for firms with small levels of market capitalization and requirements for listing is less stringent.
  2. Global Market (Midcap) includes around 1,500 stocks representing Nasdaq global markets and are required to meet strict financial and liquidity requirements. There are certain Corporate Governance Standards that have to be met.
  3. Global Stock Market (Large Cap) is a market capitalization-weighted index made up of US-based and international stocks. It is required to meet more stringent requirements as compared to the mid-cap and relatively exclusive in comparison to others. The listing department will regularly review the performance and associated rules governing these stocks.

#3 – DJIA (Dow-Jones Industrial Average)

The DJIA is one of the oldest and well-known indices in the world comprising 30 major companies belonging to the industry leaders which significantly contribute to the industry and stock market. The Dow is a price-weighted average stock market index indicating that any type of stock split or adjustment is not considered in the average price computation.

Since it represents a large section of the US market, a percent change in the Dow should not be interpreted as an equal chance in the overall market. This is due to the price-weighted function. For e.g., if the value of one stock falls from say $450 to $50, the entire stock market index may fall by around 3,000 points since the quantum of one stock weighs heavily on the base of 30 firms. As the index consists of some of the well-established companies in the US, large swings in the index can generally correspond to the entire market movement, though not necessarily on the same scale.

#4 – FTSE 100 Index (Financial Times Stock Exchange)

The stock index consists of 100 companies listed on the London Stock Exchange with the highest market capitalization which is maintained by the FTSE Group (the subsidiary of the London Stock Exchange Group). Many of these 100 firms are internationally focussed and hence may not be the best indicator of the UK economy is functioning and are significantly impacted by the exchange rate of the Pound. The FTSE 250 stock market index could be considered since it includes a smaller proportion of international firms.

The share prices are weighted by market capitalization so that larger firms make more difference to the index instead of the smaller ones. The basic Stock Index formula is:

The free float adjustment factor is the percentage of all issued shares readily available for trading. The free float capitalization of a company is calculated using the Market cap (number of shares * share price) and multiplied by the free-float factor. It does not include restricted stocks held by insiders such as ESOP’s.

#5 – Russell Indexes

Stock index is a family of global equity indices from FTSE Russell permitting investors which track the performances of specific market segments. Many mutual funds or ETF fund managers use FTSE Russell as benchmarks for measuring their respective performances. The most established index in the series is Russell 2,000 which exclusively tracks the US small-cap stocks of the Russell 3,000 stocks. The participants of the Russell 3,000 and its subsets are determined every year during the annual reconstitution with quarterly enhancements including any IPO’s. The top 1,000 companies are the large-cap ones and the others are the small-cap stocks.

The stock index has a rule-based and transparent process for forming the index by listing all firms in a descending order by market capitalization adjusted for the float (actual number of shares available for trading).

Final Thoughts

The stock index also referred to as the stock market index is an indicator of how securities of a section are performing. It’s a tool used by financial managers and investors for describing the market condition and compare the return on specific investments. The stock indexes are relatively easier to interpret and indicate live performance increasing their importance around the world.

The stock index has generally used a benchmark around the world to give a quick indication of how the stocks are performing across sectors. The movement also has a widespread impact on other macroeconomic factors such as Political and overall economy as well.

The stock index gives a quick indication of the direction in which the market is moving and also which industry/company is driving the change.

Stock Index Video

This has been a guide to what is a stock index? Here we discuss the top 5 stock market index including the S&P 500, NASDAQ, DJIA, FTSE 100 and Russel Indexes. You may learn more about stock markets from the following suggested articles –

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