A stock market index captures the behavior of the overall equity market. Movements of the index should represent the returns obtained by “typical” portfolios in the country. The most important type of market index is the broad-market index, consisting of the large, liquid stocks of the country. It reflects the changing expectations of the stock market about future dividends of country’s corporate sector. When the index goes up, it is because the stock market thinks that the prospective dividends in the future will be better than previously thought. When prospects of dividends in the future become pessimistic, the index drops.
Basic idea in an index
Every stock price moves for two possible reasons: news about the company (e.g. a product launch, or the closure of a factory, etc.) or news about the country (e.g. ruling government, public movements or a budget announcement, etc.). The job of an index is to purely capture the second part, the movements of the stock market as a whole (i.e. news about the country). This is achieved by averaging. Each stock contains a mixture of these two elements – stock news and index news. When we take an average of returns on many stocks, the individual stock news tends to cancel out. On any one day, there would be good stock-specific news for a few companies and bad stock-specific news for others. In a good index, these will cancel out, and the only thing left will be news that is common to all stocks. The news that is common to all stocks is news about the country. That is what the index will capture.
Kind of averaging
For technical reasons, the correct method of averaging is the weighted average, and gives each stock a weight proportional to its market capitalization. Suppose an index contains two stocks A and B. A has a market capitalization of $1,000 and B has a market capitalization of $3,000. Then we attach a weight of 1/4 to movements in A and 3/4 to movements in B.
Importance of INDICES
- Indices serve as a benchmark for measuring the performance of fund managers.
- Direct applications in finance, in the form of index funds and index derivatives. Index funds are funds which passively ‘invest in the index’. Index derivatives allow people to cheaply alter their risk exposure to an index (this is called hedging) and to implement forecasts about index movements (this is called speculation).
- The index is a lead indicator of how the overall portfolio will fare.