What are Stock Indices?
Stock indices, like the FTSE 100, Dow Jones Industrial Average, and Nikkei 225, are critical benchmarks often cited in financial news. These indices measure the performance of a particular segment of the stock market, which could be defined by:
- An exchange – for instance, the NASDAQ or Tokyo Stock Exchange.
- A region – such as Europe or Asia.
- An industry sector – like technology, energy, or real estate.
The FTSE 100, for example, reflects the performance of the 100 largest companies listed on the London Stock Exchange. If these companies’ average stock prices rise, the index increases; if they drop, the index will fall.
The Importance of Stock Indices
Indices provide a consolidated view of market trends, offering insights into how a specific market, region, or sector is performing. For example, the ASX 200 tracks Australia’s top 200 companies. If the index rises, it suggests that these companies—and potentially the broader Australian economy—are thriving. Similarly, movements in indices worldwide offer investors and traders a gauge of economic conditions, helping them anticipate market trends and refine their strategies.
Key Global Stock Indices
Major indices often represent the largest companies in their respective countries or regions. Some notable examples include:
- FTSE 100 (UK)
- DAX (Germany)
- CAC 40 (France)
- Nikkei 225 (Japan)
- Hang Seng (Hong Kong)
- ASX 200 (Australia)
The United States has multiple significant indices:
- Dow Jones Industrial Average (DJIA): A historic index of 30 influential companies, initially focused on heavy industry.
- S&P 500: Encompasses 500 large companies listed on the NYSE or NASDAQ, representing around 70% of the U.S. market.
- NASDAQ-100: Highlights 100 major non-financial companies, with a strong focus on technology, biotechnology, and telecommunications.
By tracking these indices, traders and investors gain valuable insights into economic health, market sentiment, and potential investment opportunities globally.
How are indices calculated?
Capitalisation-Weighted Indices
A majority of stock indices use the capitalisation-weighted system, which factors in the market value of each company. A company’s market capitalisation is calculated by multiplying its share price by the total number of shares it has issued. In this system, larger companies have a greater impact on the index’s value.
For example, in the FTSE 100, a company like BP, with a market value twice that of Barclays, would exert twice the influence on the index. Other well-known indices, including the S&P 500, NASDAQ-100, Hang Seng, CAC 40, IBEX 35, and ASX 200, also use this method. This approach ensures the index reflects the performance of companies proportionate to their size.
Price-Weighted Indices
In contrast, price-weighted indices calculate their value based on the share prices of constituent companies rather than their market value. Higher-priced stocks have a greater influence on the index, regardless of the company’s size. For instance, a stock priced at $100 would have five times the impact of one priced at $20. Many financial product providers offer high liquidity, facilitating easier entry and exit from positions while keeping transaction costs relatively low.
The Dow Jones Industrial Average and Nikkei 225 are the most prominent indices employing this method. While straightforward, this system can sometimes skew the index’s performance since high-priced stocks dominate its movements.
