There are major market indexes which are helpful in evaluating the investment results. Performance is compared against the benchmark provided by these major market indexes. The investors can conduct financial research with the help of these indexes in order to understand the relationship between particular economic variables and the market results. These indexes provide the understanding of the developments and the price changes occurred in the market.
Indexes are beneficial in analyzing the performance of an investment only when the investor has reasonable knowledge about what is measured by the index and how much similarity the considered index has with a specified investment portfolio. In fact the variables that construct the index should be viewed.
Types of Major Market Indexes
Major market indexes have the following types on the basis of their construction variables
- Price Weighted index
- Equal Weighting Index
Price Weighted Index
Price weighted index is formed of an individual share of each of component of index, regardless of the share price or the size of the company considered. DJIA (DOW Jones Industrial Average) is a good example of price weighted index. The thirty industrial companies compound this index.
The problem in this index occurs when a company in the index makes a decision to split its stock. On the first day, the portfolio composed of three stocks having one share of each has value of $60. On the second day, the Company A splits its hares 3 for 1 which results in the fall of the share price of stock A from to $10. Each of the three companies now has one share which costs total of $40. Someone who has no information about the stock splitting in the Company A will observe the fall in market index from $60 to $40 and he will find that one third of the value is lost by the market overnight. This conclusion will be definitely false because the change in the market index is accounting based. In order to tackle this problem, a divisor is used by the analyst for the adjustment of the value of portfolio before finalizing the value of the index. It is ensured by the devisor that the stock spill will not change the index artificially. Additionally there is certain interpretation problems associated with price weighted index. The first one is that the stock that has high value contains more weight than the other stock which has lower value. This become problem and distort the picture provided by the index. Additionally there is bias associated with the price weighting against the growth stock. The weight of the growth stock increased in the index as its price increased. When the price of share becomes very high the company splits its stock in order to reduce the price of its share and thereby reducing its influence in the index.
Moreover the payment of dividends is not reflected in the index. It is possible for price weighted index to begin and end the year at a value of 100.00. But it is wrong to consider that the investor in the index has gained no dividend because all the dividends received are being overlooked by the index.
The equal weighted index indicates the performance linked with the picking of a certain security by chance. For example if equal weighing index include 10 securities then its value will be based on the 1/10 performance of each of ten companies of the index. The price change provide basis for measurement of performance instead of the price exclusively. The statistical average of random selection of security indicates the equal weighting of the resulting returns. Theoretically equal weighting can be preferred to price weighting.
The calculation of equal weighting index is made by either considering the dividends or omitting them. The returns become larger by inclusion of dividends so the measure of the market activity will be biased downwardly if dividends are not included.
Capitalization weighting is also known as value weighting. In capital weighting components are weighted by the size of the company instead of the value of the share. The number of outstanding shares is multiplied by the share price. Each component of the index is summed according to this value, with the aggregate compared to some arbitrary beginning value.
Types of Popular Stock Indexes
There are a large number of stock indexes used in the world and it is not possible to make an accounting record of all of these stock indexes. New additions come and old ones with weak potential are deleting from passage of time. Following are some of important stock market indexes.
- Dow Jones Averages
- Standard & Poor’s Indexes
Dow Jones Averages
The most familiar stock market index to general public is the Dow Jones Averages which include the four primary averages which are
- Industrial Average
- Transportation Average
- Utilities Average
- Dow Jones Composite
In 1986, Dow Jones & Company introduced the Dow Jones Industrial Average which was initially based on 12 companies with 40.94 as first average value. In 1928, the index was modified and contained 30 blue chip companies as total. The lone survivor of the original group was the General Electric while the other 29 companies have either been replaced with another company or merged. The initial value of the divisor was 30 with 30 stocks in the index and due to stock splits this value was decreased to 16.67 later that year.
Altering the components of the index can result in reasonable change in what the index measures. Dow Jones Averages are rarely employed for performance appraisal purposes or in financial research because of its certain shortcomings.
There are 20 transportation companies included in the Dow Jones Transportation Average. On the hand the Dow Jones Utility Average includes stocks of 15 public utility companies. All the 65 stocks in DJIA, DJUA and DJTA are included in the Dow Jones Composite and the relevant index is sometimes called “65 stocks”. Besides these popular averages, Dow Jones releases 105 various industry groups indexes on the basic materials, consumer(cyclical), consumer (non-cyclical), energy, conglomerate, industrial, technology, utility and financial areas.
Standard and Poor’s Indexes
A large number of indexes are prepared and published by the Standard & Poor’s Corporation. There is identical method of calculation for all S&P indexes. The most widely used index is the S&P 500 Composite which is value weighted index and includes 500 NYSE-traded securities. Although the S&P 500 index contains 500 stocks but still the performance of individual stock can sway it. In fact it does not face stock split problems because it is value-weighted. A divisor is still required in the due to the following three reasons.
- In order to control the effect of replacement of a company in the index
- The issuance of additional shares by a company in the index
- The decision of the corporate to buy its own shares which takes capital out from the index.
In the time of 1941-1943, the initial value of the S&P 500 was 10.00 while that average value of shares became 1,445 in April 2000.
There are certain other standard & poor’s indexes like S&P 100, S&P 20 Transportation Stocks, S&P Financial Stocks and the S&P $0 Utility Stocks. The Standard and Poor’s declares two new indexes with the conjunction of BARRA which are designed to give benchmark for the growth and value investment styles. These are the S&P 500 value index and S&P 500/BARRA Growth Index.
Some Other Types of Market Indexes
There are certain other major market indexes too like the New York Stock Exchange which publishes its own indexes based on the transportation companies, industrial companies and utilities companies with combination of some other companies that are traded on the exchange. The average of all NYSE listed stocks is included NYSE Composite. Similarly the NASDAQ market and The American Stock Exchange develops their own indexes on their securities. Another important index is the Russell 3000 index. Moreover, an index based on securities is published in Value Line Investment Survey conducted by Line.
Fixed Income Indexes
Fixed income securities are measured by more than 400 indexes. There are different kinds of bonds on the basis of riskiness and investment characteristics. The investors should differentiate the corporate bonds, foreign bonds, short & long term bonds, tax-exempt bonds, and investment grade & junk bonds in making comparison between bonds. It is probable that the investors may find a benchmark with desired characteristics on the basis of wide range of available indexes. The Dow Jones 20 Bond Index is presented by the Dow Jones Company. There are many bond market indexes of the Standard & Poor’s Company including S&P U.S Government Bond Index and S&P Municipal Bond Index. Additional useful fixed income indexes include Salomon Smith Barney Corporate Bond Index, Indexes of Moody’s Investors Service etc.
There are many global indexes prepared as a result of increased international investment. The important international indexes are as follow
- European Indexes
- Asia and pacific Rim
The most important index in the United Kingdom is likely FT-SE, 100 which also called “Footsie 100” and is based on the 100 U.K stocks with the largest capitalization. The principal index in Germany is the DAX30 which is related to the future market. There are equity future indexes in France and Italy named CAC40 and MIB30 respectively.
Asia and Pacific Rim
The principal market in Asia is the market of Japan along with other rapidly rising markets of Singapore and Hong Kong. Japan has a price weighted index named Nikkei 225 which includes 225 stocks of large actively traded companies on Tokyo Stock Exchange. TOPIX is another Japanese index which covers about 1,200 large companies. Moreover Nikkei 300 is a capitalization weighted index of future market. Hong Kong has capitalization weighted index named Hang Seng which covers 33 stocks. Similarly Australia has capitalization weighted index named all Ordinaries Index which includes 240 stocks.