Stock index

Indices are built from baskets of individual, listed stocks, called "constituent stocks of the index." It is very useful to be able to analyze the price variations of several companies at a single glance.

A stock index is a numerical value, which is calculated based on the market prices of each of the securities that make up that index at a given time. The profitability of an index is the change in its value from one period to another.

It serves to represent the evolution of companies in a country, a certain 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 main stock indices of the world.

Functions of stock indices

Stock indices can be used for many purposes, the main ones being:

• They reflect market sentiment.
• They serve as a benchmark or benchmark to measure the performance of an asset manager. They make it possible to compare the profitability and risk (measured by the standard deviation or the sharpe ratio, for example) that this manager has obtained with that of its benchmark. It is worth mentioning that if the manager has two or more references in its investment universe (for example, it has 50% of its securities in the United States and the other 50% in Europe, this benchmark will be 50% of the value of the stock index that appropriate for each country).
• Measure the profitability and risk of a market.
• Measure the beta of a financial asset.
• Create portfolios that mimic the behavior of the index, known as indexed portfolios.
• They are the basis of some investment vehicles (such as ETFs, or financial derivatives).

How do you build a stock index?

The main ways to build a stock index are:

• Weighted price index: It is simply the arithmetic mean of the price of the securities that make up the index.

Its advantage is that it is very easy to calculate, but the big problem is that the stocks with the highest prices are going to have more influence on the value of the index, regardless of their actual influence on the economy. Two important indices that use the weighted price method are the Dow Jones Industrial Average (DJIA) and the Nikkei Dow Jones Average.

• Weighted capitalization index: It is built according to the market capitalization of each of the securities that make up the index.

This type of index is the one that most faithfully represents the reality of what is to be measured. Most of the world’s stock indices use this method of calculation. Like, for example, the S&P 500 and the IBEX 35.

• Equally weighted indices: It is calculated as the arithmetic mean of the profitability of each of the securities that make up the index.

It is not a widely used method, since you have to continually make adjustments and securities with lower market capitalization have the greatest influence. Two examples of indices that use this method are the FT 30 and the Value Line Composite Average.

Origin of stock indices

Stock indices came into use at the end of the 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 went down or rose in price together, he decided to express the trend or level of the stock market in terms of the average price of a few shares. representative. As in his time the most representative companies were those of the railways, he made two indexes, one with the 20 most important railway companies and another with 12 shares of other types of businesses.

There are currently hundreds of indexes. The most important do not represent all the companies in an economy, not even all those that are listed, 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 are relying on a stock index. This is because a stock index is a very good economic indicator.

For example, when it is said that the Spanish stock market falls by a certain percentage, they usually refer to the fact that the Spanish stock index is falling, that is, the IBEX 35, made up of the 35 largest Spanish companies.