Education

Stock Market Indices

Financial market indices are groups of stocks, used to measure particular sector of market or economy in the whole. Market indices tend to represent the investor sentiment on the entire market and help investors assess the potential of investing in particular sector of market or economy.

Generally, indexes provide a snapshot on the performance of particular market by tracking the top market components. Given the importance of indices for the performance of financial markets in general there is little surprise in the fact that investors used them for more than a century.

The first stock market index was unveiled by Charles Dow in 1896. Named “The Dow Jones Industrial Average” his index was the average of top 12 stocks in the market. Most of the companies included in the index belonged to railroad or mining sectors which account for the majority of economic activity at that time. Charles Dow calculated the index by adding the prices of all stocks in the index and then dividing the number by the number of stocks. The first known value of Dow Jones Index was 40.94. More stocks were added to the index in the future as the American economy boomed.

Most-quoted Indices

Now, the Dow Jones Industrial Average (DJIA) is the composite measure of 30 stocks traded on the New York Stock Exchange (NYSE) and the NASDAQ. Big, mostly multinational corporations are grouped in the index. Such prominent names as Boeing, General Electric, Exxon Mobil and Microsoft are just a few of multinationals placed in the Dow 30.

The NASDAQ Composite Index is heavily oriented towards Information Technology Companies. It include such companies as Apple, Google, Intel, Dell and many other recognizable names in the tech industry. Having started in 1971 with the listing of 50 companies and the valuation of 100, the index boomed to reach its all-time high of 7560 on March 09, 2018, currently having over 4,000 stocks measured.

Other notable indices are:

  • DAX – a German index consisting measuring 30 biggest companies traded on Frankfurt Stock Exchange
  • Nikkei 225 – a price weighted index measuring biggest players on Japanese market
  • Hang Seng – a capitalization-weighted index tracking daily changes in the prices of largest companies traded on Hong-Kong stock market.

The way how indices are calculated vary from across different indices. For example, The Dow Jones uses the price-weighted model meaning the price of each component is the only factor used in calculation. On the other hand, Hang-Seng uses capitalization weighted model where the small change in the price of bigger component will have a strong impact on the price of entire index. Other models, like modified capitalization weighted manage to strike a balance between equal price weighting and capitalization weighting with the only difference being that largest stocks are capped to a particular percentage of whole index weight, meaning that in case of sudden price spikes the surplus weight will be equally allocated to other stocks.

Example of How Indices Help Investors

Indices help investors to gauge the potential of the target market. In times of economic recessions indices are among the first components of the market to react to changes in economic and business climate. So, if you see that let’s say the Dow Jones has been under heavy pressure over a long period of time you may feel safe to assume something is generally in trouble. And even if your analysis suggests that you may have been doing the right thing by deciding not to sell the stock you have, general trend of index prices might be a worrying sign that your stock portfolio should be reassessed.