Overview – A Look at Market Indices
When checking a financial news outlet first thing in the morning, you may probably encounter the following headlines:
“Markets up 10% due to the positive jobs report.”
“Dow ends 200 points lower at the end of the week.”
“Strong rally from tech sector sends Dow up 400 points.”
What exactly do those numbers mean, and what are these headlines referring to?
All these headlines are referring to things known as market indices, a commonly used tool investors use daily to quickly assess the health of capital markets and the broader economy.
Of course, looking at some numbers isn’t nearly enough information to say with certainty what exactly is going on with capital markets, but at the same time, these numbers give investors a rough idea of what’s going on.
Understanding how to interpret a market index and its implications is yet another important skill every investor should possess to help them quickly gain some investment insight with limited information.
What is a Market Index?
The U.S. Securities and Exchange Commission (SEC) defines a market index as follows1:
“A market index tracks the performance of a specific ‘basket’ of stocks considered to represent a particular market of the U.S. stock market or economy.”
Of course, market indices are not limited to the United States. Most countries with a stock market also have market indices. For example, Canada has the TSX Composite, London has the FTSE 100, and Japan has the Nikkei 500.
Because market indices are simply just a basket of different stocks, they aren’t very hard to create and maintain on a daily basis. Despite its simplicity, millions of investors refer to them on some sort of recurring basis, whether it’s every few months or several times a day. Why is that?
The Purpose of an Index
Remember, when it comes to investing, the performance of a portfolio or a specific investment is only as good as what it’s compared to.
Imagine your portfolio increased in value by 10% relative to the same date last year. What do you compare your portfolio to when assessing its performance?
This is where market indices come in. One of the purposes of a market index is to serve as a portfolio performance benchmark2.
When an investor says they “beat the market” or their portfolio “underperformed”, they are most likely using an index as their reference. The index being used depends upon the investor, their portfolio composition, and which country they are in.
For example, most Americans would likely use the S&P 500 as a benchmark because it represents a large portion of the American stock market and, subsequently, the American economy.
It would make little sense for a Canadian investor, owning primarily Canadian shares, to compare their portfolio performance to that of the S&P 500, an American market index. In this scenario, it would make the most sense to draw comparisons with a Canadian-centred index, such as the TSX Composite.
Another purpose that market indices serve is to act as a quick check on the health of capital markets at a given moment, which was mentioned earlier.
One of the nice things about indices is that they can be as broad or concentrated as you want. Therefore, they can track the performance of a wide variety of stocks or a very specific set of them all in one place.
It’s impossible to check the day-to-day fluctuations of every single stock, but by gathering a basket of them you can more or less gauge the performance of all the rest.
Market indices are, in a sense, similar to taking samples in scientific experiments: you can’t possibly hope to assess every single member of a population, so you take a small sample and you assume that the observations you make in the sample also apply to the rest of the population or at least a sizeable portion of it.
This same idea applies to indices: by gathering a basket of stocks you get an approximate understanding of how other stocks similar to the ones in the index are performing.
For example, the S&P/TSX Capped Energy Index tracks Canadian energy sector stocks. It may not represent the entire Canadian energy sector, but it represents a good portion of it. Therefore, the performance of this index more or less indicates the performance of this sector as a whole.
Of course, market indices are only approximate measures of performance for a select group of stocks. The performance of a select few stocks in an index doesn’t reflect the performance of every single stock that’s related to it.
For example, if the S&P/TSX Capped Energy Index were to tank tomorrow, this suggests that energy stock prices have taken a hit, but there’s no guarantee that all energy stocks have been affected in the same way.
It’s entirely possible for an individual stock to do well but for a related index to perform poorly, and vice versa.
Creating an Index
Theoretically speaking, there are no strict requirements when creating an index. After all, a market index is just a collection of different stocks – the types of stocks that are included are entirely up to the creator. It can be argued that the reason why so many indices exist is that they’re not really that hard to make.
While an index is simply a collection of certain stocks, not every index is made the same way.
Imagine an index made up of 100 stocks, with a current index value of 10,000. Some of these stocks represent very big companies with billions of dollars of revenue, while others represent companies that make far less than that. Some have market capitalizations in the billions, while others are just shy of reaching the billion-dollar mark.
With such a diverse collection of companies, how exactly is the index value calculated on a daily basis?
Indices use different methodologies to calculate their values2. The weighting of each stock component may depend on market capitalization, revenue, or share price. In some cases, the weighting may be equally spread.
According to the SEC, a weighted index takes certain metrics such as market capitalization or share price into account1, meaning that the larger a company’s market cap or the more expensive its stock price, the greater the effect it has on an index. An example of a weighted index is the Dow Jones Industrial Average.
On the other hand, an equal-weight index is one where each stock contributes equally to the index, regardless of how large or small they are. An example of this is the S&P 500 EWI (Equal Weight Index), where each stock is weighed at 0.2% of the index total.
Common Market Indices
There are countless market indices around the world, but assuming you will get involved primarily with the Canadian and U.S. markets, then the following indices will be the ones you may frequently come across:
Dow Jones Industrial Average1
This index is composed of 30 “blue-chip” U.S. stocks. That is, these companies are some of the largest and most dominant in the U.S. The Dow Jones Industrial Average is not a weighted index (i.e., market capitalization is not considered). Companies are intermittently added and dropped from the Dow Jones.
S&P 500 Composite Stock Price Index1
The Standard & Poor’s 500 Composite Stock Price Index is a weighted index (i.e. it takes market capitalization into consideration) of 500 stocks. This index is meant to be a sample of some of the leading companies and industries in the U.S.
S&P/TSX Composite Index
The S&P/TSX Composite Index is the primary index for the Canadian stock market3. With approximately 95% coverage of the Canadian stock market, it serves the dual purpose of being a benchmark and an investable index4 (i.e., can purchase all the securities that make up an index individually).
Wrapping Up
Market indices are commonly used tools many investors use to quickly gauge the health of capital markets on a given trading day.
Indices are also used as a benchmark that investors compare their own portfolios against. When an investor says they “beat” or “underperformed” the market, chances are they are making that comparison relative to an index.
Although there are countless indices around the world, not all of them are created the same way. Some represent large swaths of the broader economy of a country, whereas others track the performance of a specific industry or sector.
Not only that but how much a specific stock contributes to an index may differ. Some indices use a weighted methodology, where different stocks contribute more than others, while in other indices each stock may contribute equally.
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