How Stock Indexes Work

If there’s one thing that captures the mood of a nation, it’s the stock market index. When the Dow Jones Industrial Average (“Dow Jones”) or Standard & Poor’s 500 (“S&P 500”) falls, the collective mood of the nation goes down; when it rises, national mood rises with it.

 

What makes stock market indexes so important?

 

Stock market indexes are used to measure the performance of the stock markets, and in this way are indicators of the economic health of the nation. They can be used as benchmarks for comparing the performances of individual stocks or even portfolios, both of individuals and entities like mutual funds.

How do stock market indexes work?

Stock market indexes consider some select stocks in the markets when coming up with a consolidated value, and the basis of this selection can be size, industry, etc. There are two major ways in which this value is calculated – price weighing and value weighing. This gives rise to the two main types of indexes – price weighted index and value weighted index, of which Dow Jones and the S&P 500 are prime examples, respectively.

In an index, each of the constituent stocks contributes a percentage of the total value. This is its weight in the index. In a price-weighted index, the price of the stock is the only determinant of this weight. Therefore, a highly-priced stock of a small company can have a larger weight than a lower-priced stock of a large company. In such a situation, price movement of even a single stock will heavily influence the value of the index even though the dollar shift is less significant.

For a value weighted index, it is the market value of all the stock or its market capitalization that determines its weight. Thus, a relatively small shift in the stock price of a large company will heavily influence the value of the index.

While traditional value weighted indexes have considered all outstanding shares when determining market value, some of the recent ones consider only the floating shares, that is, the shares in the hands of public investors as opposed to company officers, directors, or controlling-interest investors. The reason behind this distinction is that only floating shares are available for trading, and such an index may be more representative from the individual investor’s point of view.

Which are the popular stock market indexes?

The most popular stock market indexes in the US are:

* Dow Jones – Price weighted index of 30 stocks which are the largest representatives from different industries in the New York Stock Exchange and NASDAQ exchange.

* S&P 500 – Value weighted index of the 500 stocks with the highest market capitalizations in the New York Stock Exchange and NASDAQ exchange.

* NASDAQ Composite – Value weighted index of more than 5000 stocks on the NASDAQ exchange. Since non-US stocks are also listed in NASDAQ, this index is not exclusively a US stock market index.

These are only a few of the hundreds of indexes available worldwide, tens of them in the US itself. Some of the famous global ones are Hong Kong’s Hang Seng, Tokyo’s Nikkei, London’s FTSE 100 and Mumbai’s Sensex.

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What is the typical returns of mutual funds from different types of mutual funds

A mutual fund is an investment vehicle which allows an individual to be mostly diversified in his investments by owning a vast amount of stocks or a particular investment tool. The funds invested in a particular scheme are managed by a single fund manager or a team of managers. They make sure that the fund grows optimally within its investment criteria. These managers are responsible for buying and selling of securities, which is based on their research results. Mutual fund companies pool money from some investors. Each of those investors becomes a shareholder in that fund.

There are literally hundreds of thousands of mutual funds available in the market, although only few of them are considered worthwhile by the majority of investors due to its risk return trade off.

Like every other financial instrument, in mutual funds too the potential return rises with an increase in risk. Low risk is combined with potentially low returns, whereas high risk is combined with high potential returns. According to the mutual fund risk-return trade off, the money invested can only render higher profits if it is subject to the chance of eroding. Accordingly, it is really difficult to quantify returns in exact numbers since that is dependant on market conditions.

The most basal types of mutual funds which are present in the market are as follows, arranged in the order of increasing risk, and consequently, increasing returns:

1.Money market funds – This fund carries a really low amount of risk compared to others. They are considered short term high quality investment tool. This typical fund makes investments only in U.S. companies and the different levels of government. Investor losses are quite rare in this category of fund, although they have happened in the past. This is more or less the type of fund for risk averse investors.

2.Bond funds, or fixed income funds - This specific fund hold higher risk-return trade off compared to money market funds. These types of mutual funds are not limited to a certain type of investment. Here, return can vary due to different types of risks. Such risks associate: credit risk because certain parties may not pay the bills on time, interest rate risks due to fall in the value of these bonds when the interest rate goes up and prepayment risks because the bond issuer may decide to pay off debt to issue new bonds when there is a fall in the interest rates.

3.Balanced funds – This specific fund invests in different kind of asset classes such as vanilla bonds, common and preferred stocks, and short-term bonds etc. This specific instrument avoids too much risk and gives the investor the opportunity to gain consistent income and capital appreciation. Investors who have a aim to earn higher returns but are able to take limited amount of risks are able to get both income and development from this fund. These investments tend to control the crisis of the stock market better due to there portfolio balancing aspects.

4.Global equity growth funds - The value of this category of fund can rise and fall really quickly over a short duration of time. However, they do tend to achieve superior over the long-term. This fund is for investors who want to earn higher returns and are willing to take big risks in order to get it. Over a long duration of time the risk becomes almost nil which enables the investor to make colossal profits.  

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What is The Basic Methodology Behind a Stock Index

The history of the world's stock markets can be traced to the local market place, where all the villagers used to carry their goods to trade. After prevailing for centuries, this has led to the present stock exchange. Stock exchange trading in the United States started over 200 years ago. It was a time when the colonial government was forced to finance the war by issuing bonds, government notes and selling them to the public. This was backed by the promise to pay back at a profit on a later date.

In a centralized stock exchange the shares of companies are listed. These shares can be bought or sold by the investors. The index stocks listed on the stock exchange have a certain market value depending on the economic accomplishment of the company and its financial health as well as economic and investment scenario in the country. These share prices are unsteady in nature due to a number of factors including market health, investment climate and company performance.

Looking at the composition of a stock index is the most normal way to know them. There are a few general set of rules which need to fulfilled, in order to obtain listed in a stock index. The three fundamental rules are as follows: -

• All the investments in the index are subject to selection.
• Includes calculations and rules for weighting of the index components.
• Provides certain instructions for adjustments to maintain viscosity.

There are several stock index calculation methodologies out there based on which the value of an index is decided, three of which are : -

(1). Capitalization Weighted Indices

This specific process involves the total market capitalization of the companies weighted on the foundation of their effect on the index. This results in larger stocks making more of an influence, rather than a tiny cap company. This is also known as the free float procedure.

(2). Modified Market Capitalization Indices

This method involves, hybrid between equal weighting and capitalization weighting.

It is very much identical to the a general market cap, although the largest stocks arecapped to a absolute percentage of the weight of the total cumulative stock index. Here, the excess weight gets redistributed equally amongst the stocks under that cap.

(3). Price Weighted Indices

A price-weighted stock is also known as the equal-weighted stock index, because fluctuations in the stock values have no adverse influence on the index. The stocks which are included in the index are based on their quoted price. E.G. A $100 stock will have twice the proportion of a $50 stock. This procedure gives a big amount of importance on the total equity of the stock in the market. The Dow Jones Industrial Average is the most popular example of a price-weighted index.

In the end, out of all the methodologies, the Broad Based Index is considered the most absolute manner to show the benchmark of a stock index. It covers all the scrip’s in an exchange. This is also known as Composite Index. It acts as a proxy for the accomplishment of the economic conditions of the whole market. 

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