The main stock market indices: how they work
A stock index is a collection of individual stocks that belong to a certain category or share certain features. These groupings can be large (like a mix of large, mid and small cap stocks from various sectors) or narrow (like having only stocks from a specific sector like food producers or auto manufacturers).
These groups are like an indicator, representing their sector or group as a whole. They help investors easily monitor the economic health of a market or industry, much like they would monitor an individual stock to determine the economic health of a specific business.
For example, the Nasdaq composite index is known for containing mainly tech stocks. In theory, one can look at the performance of the Nasdaq and find out whether the tech sector is growing or declining, by comparing its value in the past to its current value.
This is exactly what professional portfolio and investment managers do all the time. Not only do indices give investors a quick overview of a sector or market, but they are also used by mutual fund and exchange-traded fund (ETF) providers to compare returns and performance on that sector or market.
How do stock market indices work?
All indices have a composite number, based on the value of the stocks that compose them; for British indices, it is expressed in pounds. But this is not necessarily a simple total or an average.
All indices include groups of stocks, but the overall performance of each individual stock is weighted. Stocks with a higher weight have more influence on the performance of the index, and stocks with a lower weight have less influence. In general, indices are weighted in several ways:
- Weighting according to market capitalisation
- Weighting according to price
- Equal weighting
Market capitalisation-weighted indices, such as the S&P 500, give more weight to large companies with a higher market capitalisation (that is, the total market value in dollars). For example, Apple, which weighs over $2 trillion (yes, you read that right!), represents 5.5% of the S&P 500 index.
Price-weighted indices give more weight to the higher-priced stocks. For example, in the Dow Jones Industrial index, which consists of 30 stocks, the shares of UnitedHealth Group, which are priced at $339 per share, are more heavily weighted than those of Cisco Systems, whose share price is only $43 per share.
Finally, equally weighted indices weigh each share at the same level, regardless of the cost of a share.
There are other stock market indices that use proprietary methods to establish weights. For example, some indices assign weights based on the dividends paid out by a stock. However, market capitalisation-weighted indices are the most popular, as they are often the easiest for index funds to follow.
How does one interpret a stock market index?
Stock indices are a key way to measure the financial strength and performance of various stocks, industries and other market segments. The returns of individual stocks, asset classes and investment funds are often compared to those of an appropriate index.
The largest and most established indices, such as the FTSE, act as duplicates for the entire stock market. Their upward or downward shifts can help predict the direction of national and even global economies.
And, on a smaller scale, a stock market index can serve as a guide for an individual to choose his or her investments. But don't forget: at the end of the day, it's still just an indicator.
To correctly interpret a stock market index, you have to examine how its value changes over time. New stock indexes always start with a certain fixed value based on the stock prices on their start date. Over time, the future values of the index measure the rise and fall of the prices of the constituent stocks.
However, not all stock market indices use the same starting value, so simply measuring changes in the index using points can be misleading. For example, if one index increases by 500 points in one day while another increases by only 20 points, it may appear that the first index performed much better. However, if the first index started the day at 50,000 while the second index was at 500, then you can see that in terms of percentage the gains for the second index were more significant. A higher percentage payout means a bigger profit for you if you invest in funds that track the index, so it's better to focus on percentages than on point movements.
In addition, even the most popular stock indexes generally do not measure the performance of the overall market. Knowing which stocks are part of an index can tell you which parts of the stock market are contributing to that index's performance and can explain why other indices aren't behaving the same way.
How are stock market indices used?
The following reasons illustrate how the monitoring of stock market indices can be useful:
- Tracking the most widely followed stock indexes can give you a general idea of the health of the stock market as a whole.
- Tracking lesser-known indices can help you see how a particular market segment is performing relative to the market as a whole.
- If you don't want to invest in individual stocks, but just want to follow the performance of the market as a whole, a profitable way to achieve solid returns over time is to invest in index funds that track the stock indexes you're most interested in.
Stock indices make it easier to see how the market is performing without having to follow the highs and lows of each stock. They also offer simple investment opportunities that even novice investors can use to participate in the stock market's long-term profitability.
Warren Buffett says: "By periodically investing in an index fund, for example, the ignorant investor can actually outperform most investment professionals".
Active vs Passive investing
When it comes to active investing, portfolio managers use their skills to try to outperform the general market. They generally seek to identify stocks with high growth potential over the long term. Active investing generally involves higher management fees and transaction costs, as the holdings of the portfolio are likely to change much more frequently than with a passive investing strategy. Also, an active approach can be affected by market surprises and managerial biases.
The holdings of actively managed portfolios are sometimes more diversified than those of index-based portfolios. The portfolio manager may invest in national stocks, international ones and in asset classes other than stocks. For example, part of the holdings of an actively managed portfolio may consist of bonds, gold or silver or foreign currencies.
In contrast, index-based equity portfolios will only invest in domestic stocks. The holdings of the portfolio will, as far as possible, reflect the holdings of the underlying benchmark chosen. The holdings of the portfolio only change when the composition of the underlying index changes.
Are index funds a good investment?
In recent years, index funds, ETFs, and mutual funds have consistently outperformed actively managed funds. In general, index funds can be a very good investment. However, before investing, you need to conduct some due diligence regarding index funds and ETFs, as they aren't all are the same. Some investors may find their own answers, and others may need the help of a financial advisor.
Rather than trying to beat the market by selecting individual stocks, these funds hold all of the stocks that make up the index, which matches the performance of the underlying benchmark. This investment method has many advantages: lower fees, less reliance on the skills of a fund manager (many of which fail to beat the market!), and market-wide diversification make index funds one of the safest ways to invest your money.
The biggest advantage that index funds have is their ability to capture the returns of history's longest stock market rises. Over the past 10 years, the SPDR S&P 500 ETF Trust (ticker: SPY), an exchange-traded fund that mimics the S&P 500 Index, has enjoyed an amazing average annual return of over 11%, which is better than what many individual investors have been able to achieve.
Investors have responded to the impressive performance of index funds by fleeing actively managed funds and placing their money in passively managed funds. According to Morningstar, in 2020, investors withdrew a net total of $204 billion from actively managed U.S. stock funds, while passively managed funds saw investors pay $162.7 billion into them. It is the culmination of a trend that has lasted for years, marking the first time in history that the total assets of passive funds have exceeded that of active funds.
Are index funds safe?
Just because index funds can be volatile in times of financial crisis doesn't mean investors should stay away from them. They need to assess their risk tolerance in light of the shrinking funds and understand that index funds remain the best option in this wild roller coaster environment. The most important factor in a fund's long-term returns are the fees. With index funds now with expense ratios close to zero, this is even better than any actively managed fund. Also, active management is notoriously underperforming in times of volatility because it is ill-suited to the market - this is another reason to stick with index funds.
Index funds are also much more tax efficient, which is very important in volatile markets to maximize after-tax returns.
But does sticking to index funds mean leaving potential gains on the table? After all, the recent market recovery that followed the Covid-19 virus pandemic is the result of the rise of a few core industries, namely technology, while other sectors, such as travel and hospitality, have largely lagging behind. But, although the diversification of index funds is a great asset when the market as a whole is on the rise, and if the gains are fragmentary, then index funds can be overshadowed by the gains of actively managed funds.
Active management can be an effective approach, as good managers can take advantage of short-term opportunities caused by movements in large markets to outperform index funds. However, research has shown that it is difficult, and impossible, to identify active managers who consistently outperform, net of fees.
Fees are the hidden costs of actively managed funds that reduce your profits. These fees typically take the form of a management fee, operating expense, or expense ratio - a calculation of the operating expenses of a mutual fund divided by the average total value of the fund's assets. For actively managed funds, the expense ratio typically ranges from 0.4% to 0.9%, and even 1.4% for more expensive funds. While these numbers may seem small, they add up over time and eat up a good portion of profits. In contrast, the expense ratio of passive index funds is often closer to 0.15%.
The best index fund for you
If you think that the market is recovering and that things will continue to improve, what is the best index fund to invest in if you're bullish?
Typically, index funds that focus on smaller or foreign stocks or more cyclical companies tend to be riskier, but offer the prospect of potentially higher returns over the long term. These funds may be suitable for investors with a higher tolerance for risk and a more optimistic outlook.
Index funds that invest in large US companies, like the S&P 500, tend to be less volatile than the above options. Balanced funds (comprising a mix of stocks and bonds) can also be a way to hedge against declines.
Key points to remember
Index funds are always a good choice, but it's important to remember why you would choose index funds in the first place. Index investing is based on the belief that you cannot always choose the "best" individual investments. To be successful, you have to accept the market average and obtain it profitably.
It is also important to keep your personal investment horizon in mind. If you only think about short-term performance relative to other funds, you may always find a reason to regret choosing index funds. This is the nature of strategy.
The world's main stock market indices
- The FTSE 100 Index (Footsie): The FTSE 100 Index, or Footsie, is a stock market index of the top 100 companies listed on the London Stock Exchange that have the largest market capitalisation.
- Dow Jones Industrial Average: The Dow (DJIA, Dow 30, Industrial Average, DJI) is one of the most followed stock market indices in the world and the second oldest US index.
- The NASDAQ Composite is an index of over 3,500 common stocks listed on the NASDAQ stock exchange. The index is one of the US's most followed indices, along with the Dow Jones Industrial Average and the S&P 500.
- The Standard & Poor's 500 (US stock market index): The S&P 500 is considered one of the main representations of the US stock market, and is therefore one of the most popular stock indices among traders.
- The Nikkei 225 is considered an important measure of the Japanese stock market and the performance of Japan's economy. It includes the top 225 Japanese companies listed on the Tokyo Stock Exchange.
- DAX 40 - the German index of the Frankfurt stock exchange: the Deutscher Aktien index, or DAX 40 index, is a stock market index that groups the 40 largest German companies listed on the Frankfurt stock exchange.
- CAC 40 - the stock market index of the Paris stock exchange: The CAC 40 index is France's benchmark stock market index. It features the 40 largest stocks listed in France, measured in terms of liquidity and market capitalisation.
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