Understanding Stock Market Indices- What Stock Market Indices Tell About The Market- Part I
We keep on hearing news that Dow is up and so the market is great and vice versa. This might give you an impression that the Dow Jones Industrial Average or Dow is the heart of the market. Then you also hear about other indices like S&P 500 or the Nasdaq Composite further confusing you whether to be positive about the market or not. Lets try to understand these indices and what they try to tell us about the market.
What is an Index?
A stock market index is a way of measuring performance of certain stocks in stock market. Stock market index by itself is not such an important number. What is important is the change from an original or base value. An up or down movement gives an indicator of how the particular segment of stock that the index covers is performing and thus how the overall stock market is performing.
There are various way of classifying stocks into stock market indices. There are global stock market indices like MSCI world and S&P Global 100 which tracks companies irrespective of waht their home country is or where they are traded. Then there are the most widely used national indices like British FTSE 100, the French CAC 40 which tracks the performance of the stock market of a given country. These indices are normally composed of the largest companies listed on a country’s largest stock exchanges. There are also indices created to track the performance of specific sectors. For example-The Morgan Stanley Biotech Index tracks the performance of the 36 biggest American biotechnology firms.
How are index calculated?
Broadly Indices are either Price weighted or Market Value weighted. Price weighted index is simply calculated by dividing the sum of prices of stocks included in the index with the total number of stocks. Thus in price weighted index like the Dow, price is the only consideration for determining the value of index. No consideration is given to the market value of the company while calculating the index. A Change in price of $1 stock is same as change in price of a $50 stock.
Market-value weighted or capitalization-weighted index are same as price weighted index except that in these weights are given based on the market capitalization. Hence the change in price of stock of $1 million Company has a smaller impact on the index than the change in price of a $100 million company. Majority of stock indices around the world are market value weighted index.
