With millions of companies worldwide, it can be tough to know how a particular industry or economy is doing. This is why stock market indexes are useful. Because they track the performance of several companies, they are commonly used as benchmarks for market performance.
If you’re an investor, business owner, economist, or occupy a finance-related role, knowing about stock market indices and how they work is essential.
In this article, we review what they are, the types of indexes, how they’re calculated, and 5 useful things to remember when working with them.
Let’s start with a definition of what the stock market index is.
What Is a Stock Market Index?
Stock market indexes collectively represent the stock performance of several companies. These indices group together different companies based on geography, industry, market capitalization, and other relevant criteria.
The data is updated regularly so those using them can compare current prices against previous levels without having to follow the performance of various individual stocks.
You’ve probably come across these notable and often used indices:
- The Dow Jones Industrial Average tracks 30 of the largest traded US companies that are engaged in industrial activities.
- Nasdaq monitors the performance of more than 2,900 companies. This index is focused on technology.
- The Russell 2000 is considered the best benchmark for small-cap US stocks. It monitors the performance of 2,000 smaller companies from the Russell 3000 Index.
- The S&P 500 reflects the overall stock market performance of 500 large companies based on market capitalization.
Types of Stock Market Indexes
To cater to different investors, stock market indices select publicly listed companies based on certain criteria. Here are the types of stock market indexes you’ll come across:
- Global indexes monitor the performance of companies globally.
- Country indexes provide a snapshot of how different companies are doing in a certain country.
- Sector indexes reflect the performance of different industries like technology, consumer goods, finance, and healthcare.
- Value indexes show the collective performance of securities that are considered undervalued based on available financial information.
- Growth indexes represent companies where faster than average growth is anticipated.
- Environmental, social, and governance (ESG) indices take into consideration companies that are doing well in terms of environmental standards, how they treat their employees and society in general, and how well they’re managed.
What Is the Index Value Based On?
Ever wondered what the stock market index value is based on? Indexes usually employ market cap weightage or price weightage to determine their values.
Let’s take a closer look at what these mean…
Market Cap Weightage
Market cap weightage takes into account the market capitalization of different companies. The market cap is derived by multiplying a company’s outstanding shares by the current cost of a single share.
Using this method, companies with higher capitalization have a greater influence on the index’s performance compared to those with smaller market caps.
The value of price-weighted indices is derived by adding together the prices of each stock represented in the index and dividing the sum by the number of companies.
With price weightage, higher importance is given to stocks that are higher priced.
Importance of Stock Market Indices: 5 Things To Remember
Here are 5 reasons why stock market indexes are invaluable:
#1. It Helps in Stock-Picking
There are over 40,000 publicly listed companies globally with around 10% of them located in the United States. Indexes are useful for stock-picking because each index tracks and shares the performance of several companies.
Since they’re strategically grouped based on important aspects like the country where the stocks are listed, certain industries, market capitalization, etc., investors don’t have to sift through as many publicly traded companies to find the type of investment they’re looking for.
Here are some examples: If you’re looking to invest in large companies, you’ll take a look at the S&P 500. Investors looking for opportunities within the London Stock Exchange will refer to the FTSE (Financial Times Stock Exchange) 100 Index. Those interested in large-cap technology companies will take a look at the NASDAQ-100 Technology Sector Index (NDXT).
#2. Quick Way to Monitor Performance
Instead of monitoring how individual companies are doing, indexes can quickly provide a general idea of how different markets are doing.
This is one of the reasons why index funds have become popular among investors. Since this type of investment is based on the performance of selected indexes, they allow investors to easily monitor the status of their investments and quickly identify if an index’s value is rising or falling.
#3. Indexes Serve as Benchmarks
A third advantage to using market indices is it gives investors performance benchmarks. This can help investors gauge how a company is doing compared to the rest in the industry and helps them manage their portfolios accordingly. If a stock offers higher returns than the index, it’s said to outperform the market. Lower returns indicate an underperforming stock.
#4. Reflects Investor Sentiment
Investor or market sentiment refers to the general feeling that investors have for certain markets or securities. When prices are rising, it usually indicates a positive sentiment and a high demand. In contrast, prices fall when there are more sellers in the market and investors become more conservative and bearish.
#5. Access to Historical Performance
Similar to stocks and other financial instruments, stock market indices can be used to analyze an index’s historical performance. By knowing how an index performed within a given period, investors can identify important price levels which can guide investing decisions.
Stock market indices are helpful in monitoring the performance of stocks across companies, leading to better investment decisions. Having a good grasp of what they are and how they work will help you manage your portfolio more wisely and profitably.
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