A stock index is a benchmark index that is formed by a set of securities quoted on a stock exchange. Indices are created with baskets of quoted and individual securities, which are called ‘index constituent values’. It is very useful to be able to analyze the price variations of several companies at a glance. A stock index is a numerical value, which is calculated based on the market prices of each of the values that make up that index at a given time. The profitability of an index is the variation in its value from period to period.
It serves to represent the evolution of companies in a country, a particular sector of the economy or a type of financial asset. The stock indices that bring together the main companies in a country are an excellent indicator of the economy. See the world’s leading stock indices.
Stock indices can be used for many purposes, the main ones are:
They reflect market sentiment.
They serve as a benchmark or benchmark for measuring the performance of an asset manager. They allow you to compare the profitability and risk (measured by the standard deviation or sharp ratio for example) that the manager has obtained with that of its reference index. It should be noted that if the manager has two or more references in his investment universe (for example, he has 50% of his values in the United States and the other 50% in Europe, this benchmark will be 50% of the value of the corresponding stock index for each country).
- Measure the profitability and risk of a market.
- Measure the beta of a financial asset.
- Create portfolios that imitate index behavior, known as indexed portfolios.
- They are the basis of some investment vehicles (such as ETFs, or financial derivatives).
- How is a stock index built?
The main ways to build a stock index are:
Weighted price index: It is simply the arithmetic average of the price of the values that make up the index. Its advantage is that it is very easy to calculate, but the big problem is that stocks with higher prices will have more influence on the value of the index, regardless of its actual influence on the economy. Two major indices using the weighted pricing method are the Dow Jones Industrial Average (DJIA) and the Nikkei Dow Jones Average.
Weighted capitalization index: Built according to the market capitalization of each of the values that make up the index. It is the most faithfully representing the reality of what you want to measure. Most stock indices around the world use this calculation method. For example, the S&P 500 and IBEX 35. Equal weighting indices: Calculated as the arithmetic mean of the profitability of each of the values that make up the index.
It is not a widely used method, as you have to be continuously making adjustments and have more influence the values with lower market capitalization. Two examples of indexes that use this method are the FT 30 and the Value Line Composite Average.
Origin of stock indices
Stock indices were first used in the late 19th century, thanks to Charles H. Dow. This American journalist was a great observer of the stock market and after observing that the shares of most companies were falling or scending price boards, he decided to express the trend or level of the stock market in terms of the average price of a few representative shares. As the most representative companies were the most representative companies at the time, making two indices, one with the 20 most important railway companies and one with 12 shares of other types of business.
There are currently hundreds of indexes. The most important do not represent all the companies in an economy, not even all those that are quoted, but are made up of those that are the most significant (in general, the largest). So when journalists talk about the stock market going up or down, they’re relying on a stock market index. That is, because a stock index is a very good economic indicator.
For example, when the Spanish stock exchange is said to fall by a certain percentage, they usually refer to the Spanish stock index being lowered, i.e. the IBEX 35, made up of the 35 largest Spanish companies.