Financial Concept even Smart (but Non-Financially Literate) People Might Not Know

What is Stock Market Index really?

 

You probably know what a stock market is, but for those that don’t, a stock market is, literally, a market for stocks. It is a place where people buy and sell stocks.

But as simple as it sounds, people are often confused by comments like “the stock market was up 2% today”. What does it really mean? Does this mean more stocks were up than down today? Is the average “gains” about 2% higher than the average “losses”? Are we talking about the entire stock market, or just a part of it?  If the latter, which part? Confused?!

And then there is usually this banner we see all the time at the bottom of our TV screens:

what is stock market index

We get the first one right?  It has something to do with the currency! It probably means the Euro was 1.6% weaker against the US dollar overnight.  Or maybe it’s the other way around…which is it?!

But let’s forget currency for a moment.

What are these “Nasdaq” and “Dow” numbers? You see it everywhere. Surely it is important if it’s on prime time TV?

Enter Stock Market Index

What many people don’t realise is that when investment professionals (or TV commentators) refer to the performance of a particular “stock market” (like when they say “the US market was down 2% today”) they are often referring to just a segment or potion of the entire market.  And almost certainly, the “stock market” that they refer to is really a “stock market index” – for example, the “Dow”, which is short for the Dow Jones Industrial Average Index, is a stock market index.

So what is a stock market index?  

Well, if you know what an “index” is, you’ll know it’s just a number.  To be precise, it’s a statistical compilation of a bunch of things (e.g. the share prices of a bunch of companies).

Imagine if you will, a country with 1,000 companies. Each company has its share listed on the local stock market.  Of these 1,000 companies, let’s say, the top 10 make up 97% of the entire stock market (in terms of size), and collectively, these 10 companies represent what the country’s economy is like.

On any given day, if the combined share value of these top 10 companies decline by 5%, chances are, the overall share market would decline by around 5% as well. Intuitive right? Of course, how the other 990 companies perform on that day would certainly influence the magnitude of the overall market’s decline, but one would expect the impact to be negligible (perhaps the stock market would end up finishing between -4.9% or -5.1%).

How the top 10 companies perform thus provides a good approximation of the general performance of this country’s stock market. This is essentially the concept behind a stock market index.

So back to some stock market index examples.

The “Dow”, or Dow Jones Industrial Average Index, is made up of 30 large American companies. Yes, only 30, despite there being thousands of companies listed on US stock markets. Another interesting fact: these 30 companies are not even the 30 largest companies in the US.  But nevertheless, historically, there has been a strong relationship between the performance of the “Dow” and the broader stock market.

The S&P 500 is another widely known stock market index.  As you can probably guess by its name, the S&P 500 is made up of the 500 largest stocks in the US.  “S&P” is short for Standard & Poor’s, the firm that created and maintains the index.  Unlike the “Dow”, the S&P 500 provides a better coverage of the US stock market, as the top 500 companies represent approximately 75% of the US stock market.

And lastly, the Nasdaq is another highly followed index, and is largely made up of technology and growth companies.  Remember the dot-com bubble?  The Nasdaq fell approximately 50% within a year of reaching its peak in March 2000.  It went on to record almost an 80% peak-to-trough decline in less than 3 years (March 2000 to October 2002).

Each country generally has its own set of stock market indices.  In Malaysia, the widely accepted index is the KLCI, or Kuala Lumpur Composite Index (comprises 30 of the largest companies listed on the KL Stock Exchange).  There are also World stock market indices, for example, the MSCI World Index, which comprises over 6,000 stocks from 24 developed countries around the globe.

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