If you’ve ever picked upon a copy of the Financial Times, or have perused the business news on the Wall Street Journal, you’ll have likely read something about a stock market index.
But what is a stock market index and how do investors interpret what they read about them? Can stock market indices help you form an expectation on the latest outlook for the stock market?
Do all investors need to keep a close eye on stock market indices or are they only relevant to a sub-group of investors?
What is a stock market index?
A stock market index is a basket of shares. The value of an index is the value of all of the shares included in that basket. An index gives investors a quick way to gauge the overall pricing level of the stock market.
Each index is the brainchild of a specific organization, who provides pricing information for the basket of companies to corporate customers for a fee.
For example, the London Stock Exchange owns the company which calculates the FTSE 100 index. Delayed pricing is freely available online, however, an exchange traded fund such as the iShares FTSE 100 ETF will need to pay FTSE for live data and the privilege of using the FTSE 100 trademark in the fund name.
Not everyone is prepared to pay! UK radio listeners may notice that BBC Radio 4 news report on the price of the ‘UK 100 shares index’, which is a generic (cheaper) alternative index to the FTSE 100.
What are the most popular stock market indices?
The most commonly referenced indices are:
S&P 500 – 500 of the largest US companies
Dow 30 – 30 of the largest US companies
FTSE 100 – 100 of the largest UK companies
Nikkei 225 – A selection of Japanese companies
Hang Seng Index – A measure of the Hong Kong stock market
MSCI Emerging Markets Index – A huge basket of companies listed on the stock exchanges of emerging markets which includes Chinese, Indian and Brazilian businesses.
Nasdaq – An index based on the Nasdaq stock exchange – one which specialises in ‘dotcom’ technology companies such as Microsoft, IBM and Cisco and modern challengers such as Netflix and Google.
What companies are included in an index?
Contrary to popular belief, indices like the FTSE 100 and Dow 30 don’t simply use the largest 100 and 30 listed companies respectively to form their indexes.
As any of the best personal finance books will explain; index makers apply a set of rules and filters that the largest companies must pass before they can be considered for inclusion;
Ownership: Over 25% of the shares must be in public hands and capable of being traded on the stock exchange.
Good governance: The company must conform to a high standard of corporate governance.
Legal Structure: The index will only be formed of public companies. Venture Capital Trusts, for example will not be included even though their units are traded on the stock exchange.
These rules ensure that the index is full of highly invest-able trading businesses, rather than funds that simply invest in other companies.
Year on year, the composition of the index will be periodically updated as the market values of companies rise and fall, resulting in companies being ‘demoted from’ or ‘promoted to’ the index so that it remains relevant and representative of the broader market.
How do investors use stock market index information?
Major stock market indices are designed to be representative of the wider stock market, and therefore investors interpret news about the index level as a rough approximation to how their own portfolio will be performing.
This allows investors to keep their finger on the pulse of the stock market without needing to log into their stockbroker account or stocks & shares ISA on a daily basis. If the Dow 30 has plunged by 30%, you know that your shares and funds will be suffering too.
Many investors invest directly in passively managed funds that aim to closely track the value of the FTSE 100 (usually by investing in the same basket of companies). For these investors, keeping track of the FTSE 100 almost negates the need to check up on their fund performance!
Thanks for reading our article on ‘What is a stock market index and why are stock market indices important?’
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Do you have a question that I haven’t already answered? Please leave a comment on this article and I’ll be sure to create a fresh article to cover your investing question in detail. Check out the best stocks & shares books for more investing knowledge.