The breadth of the stock market can make it seem like there’s too much information for investors to handle. Luckily, some alternatives offer traders an easier way of identifying trends within the market. One of the alternative ways of looking at the stock market is through a stock index.
Stock indexes explained
A stock index measures and reports changes in the value of a group of selected stocks. A stock index endeavours to represent the general trend of a national, regional, or international stock market. Usually, an index employs a weighted average of share prices in which companies with a larger market cap feature disproportionately. In other words, the stock index evaluates the pulse of a whole stock market.
Stock indexes provide an excellent tool for investors to measure key performance indicators (KPIs) of the stock exchanges on which they trade. Traders have an opportunity to compare the performance of the stocks they hold (or wish to hold) against the general performance of the wider market. Examples of stock indexes include the Dow Jones Industrial Average, the FTSE, S&P 500, and many others.
Types of stock index
There are different types of indexes, depending on their purpose and the section of the stock market they focus on:
A global index covers stocks drawn from across the world. A prime example of such as index is the Morgan Stanley Capital International (MSCI). This index covers at least one stock from every continent and is market capitalization-weighted. Such an index is crucial for investors who would like to diversify their portfolio.
Regional indexes cover stocks drawn from regions defined either geographically or according to income. As such, some indexes cover stocks from Asia or Europe, while others cover regions such as Emerging Markets or Frontier Markets. Examples of regional indexes include the FTSE Developed Asia Pacific Index.
National indexes pick stocks confined within sovereign borders like the USA, the UK, Canada, Japan, or China. These indexes reflect the performance of the economy of the country in which they operate. National indexes are among the most followed within and outside their domiciled countries. Examples of such indexes include the Nikkei 225 in Japan and the S&P 500 in the U.S., among others.
Sector indexes are quite specialized in that they cover stocks from a specific industry or sector. Other indexes under this category cover certain types of stocks such as large-cap stocks, growth stocks, or value stocks. For example, the Morgan Stanley Biotech Index covers stocks exclusively drawn from the biotechnology industry. On the other hand, the S&P 500 Value Index tracks stocks based on a measure of their value.
Exchange indexes are indexes that track the performance of specific stocks on a specific exchange. For instance, the SSE Composite Index tracks the performance of all the stocks traded on the Chinese Shanghai Stock Exchange, while the NASDAQ-100 follows the top 100 stocks traded on the NASDAQ. Interestingly, some indexes track a number of stocks traded on a group of exchanges. Some examples of such indexes include the OMX Nordic 40 and the Euronext 100.
Stock indexes are crucial instruments that investors can rely on to reduce the risk exposure in their portfolios. In addition, there are exchange-traded funds that track the performance of certain indexes, which give investors an opportunity to leverage the reduced risk associated with such indexes. In this case, an investor will not have to buy individual stocks within an index, but rather the whole index. Ultimately, the investor gets to earn from the collective growth of the whole index without suffering losses from individual components that might lose value.