Why indices matter on the stock market

Stock indices help you look at the market more broadly than through the lens of a single company. The change in the price of one firm does not yet show what is happening on the whole stock exchange. A company may lose value for reasons connected with its own activity, but it may also move similarly to many other firms under the influence of the economic situation, changes in interest rates or investor sentiment. An index lets you capture this difference and better understand whether the change you observe concerns one firm, part of the market or a larger group of companies.

This is exactly why indices often appear in market commentary and analyses. They form a point of reference that helps assess the scale and direction of changes. Thanks to them it is easier to notice whether it is mainly the largest companies that are gaining in value, or whether the improvement covers a broader part of the market. This is one of the basics that help you better understand what is happening on the stock market.

What a stock index is

A stock index is an indicator that shows the change in value of a selected group of companies listed on the stock exchange. Such a group is not random. Every index has its own rules for selecting firms. Sometimes it covers the largest companies on a given market, sometimes businesses from a particular sector, and sometimes firms from many countries linked, for example, by size or the character of their activity.

The simplest way to imagine an index is as the combined result of a group of companies. Instead of looking at the behaviour of one firm, we look at the common picture of a larger whole. If a large part of the companies in the index rise, the index usually rises too. If many of them lose value, the index most often falls. Such an indicator does not say everything about the market, but it gives an important point of reference.

If you hear that an index has risen by 1%, it means that the group of companies covered by this index as a whole increased its value according to particular rules of calculation. It does not mean that every company rose by exactly 1%. Some may have risen more strongly, others more weakly, and some may even have fallen. The index therefore shows a combined result, not identical behaviour of all its elements.

How an index is calculated and where its value comes from

This question comes up very often, and rightly so. The mere statement that an index shows the behaviour of a group of companies is not enough if you do not know how such a result is calculated. In practice there are several methods, but the most common is weighting by market capitalisation.

Market capitalisation is the value of a company calculated by multiplying the number of shares by the price of one share. If a firm has 10 million shares, and each costs 20 units of currency, its capitalisation is 200 million. The larger a company's capitalisation, the greater the influence it can have on the result of the index.

In a simple example, let us imagine an index made up of three companies. Company A has a market capitalisation of 500 million, company B 300 million, and company C is worth 200 million. The combined value of these firms is 1 billion. This means that company A's share of such an index is 50%, company B's 30% and company C's 20%. If company A's market capitalisation rises by 10%, and the other firms do not change their price, the index will also rise, because the largest company strongly affects its result. If only the smallest company rose, the movement of the whole index would be much weaker.

This is a very important observation. A rise in the index does not always mean that the situation has improved evenly among all companies. Sometimes a few very large firms pull the index up, even though many smaller businesses behave averagely. This is why the reading of the index itself is only the beginning of analysis.

Types of indices

There is no single universal index for the whole world of the stock market. Indices are divided into different groups, and each of them shows something different. The most basic are broad market indices. They cover a large group of companies from a given country or market and let you assess the general direction of quotes. This group includes, for example, the S&P 500 in the United States or the FTSE All-Share in the United Kingdom.

The second important group is indices of the largest companies. They bring together the firms of the greatest value and usually of high trading liquidity.

Liquidity means that a given company's shares are bought and sold often, so making transactions is easier.

In Germany this role is played by the DAX, and in France by the CAC 40. In the United States a similar role is played by the Dow Jones Industrial Average.

There are also indices of medium-sized and smaller companies. They show a segment of the market that often behaves differently from the largest businesses. In the United States this function is performed, for example, by the Russell 2000, which covers smaller firms. Thanks to this you can see whether only the largest firms are rising, or whether the improvement concerns a broader group of businesses.

Another category is sector indices. They cover companies from one industry, for example banking, technology, energy or healthcare. Their role is very practical. They help assess whether a change in quotes concerns a single firm or a whole sector. If most banking companies fall, the problem may result from the situation in the whole industry, not only from the results of one firm.

There are also regional and global indices. This is especially important for people who want to understand the market more broadly than through the lens of one country. Regional indices cover companies from a particular geographical area, for example Europe or the developed markets of Asia. Global indices gather firms from many countries and let you follow the general picture of the global stock market.

The most important indices

On a single national market you usually find several indices that cover different segments of that market.

A broad market index shows a wide range of shares listed on a national stock exchange.

An index of the largest companies focuses on the biggest firms on that market.

Mid-cap and small-cap indices let you look at medium-sized and smaller firms respectively.

Even this division shows that a single stock exchange is not uniform. Large, medium and small companies can behave in different ways.

In Europe people often follow the DAX in Germany, the CAC 40 in France, the FTSE 100 in the United Kingdom and the EURO STOXX 50, which covers the largest companies in the euro area. Thanks to these indices you can assess what the situation looks like on the largest European markets. In the United States, the S&P 500, the Dow Jones Industrial Average and the Nasdaq Composite appear very often.

The S&P 500 is regarded as one of the most important indicators of the broad US market.

The Dow Jones covers a smaller number of large companies and has a long history.

The Nasdaq Composite is strongly associated with technology companies, though it also covers other firms listed on that exchange.

In Asia it is worth knowing at least a few names.

The Nikkei 225 shows the behaviour of an important group of Japanese companies.

The Hang Seng refers to the market in Hong Kong.

The Shanghai Composite concerns companies listed on the stock exchange in Shanghai.

A beginner Elegant Investor does not, of course, have to know all the indices by heart. It is worth knowing, however, that the stock market is not only Europe and the United States. Asian indices also play a large role, because the world economy is interconnected.

If we look even more broadly, global indices appear, such as the MSCI World or the FTSE All-World. They do not describe one country or one stock exchange. They show the behaviour of a large group of companies from many countries. This is useful when someone wants to understand what the situation on the stock market looks like on an international scale.

What an index tells a long-term Elegant Investor

In long-term investing an index helps assess whether the changes visible in a portfolio or on the chart of a chosen company result mainly from the situation of that firm, or from the behaviour of the broader market. Such a point of reference is needed, because the result of a portfolio or a single investment alone says little if you do not know what was happening on the stock exchange at the same time. A rise of 5% can be interpreted one way when the broad market rose much more strongly, and another way when most companies were under downward pressure.

An index also helps you look properly at the volatility of share prices. A fall in the price does not always mean a worsening of a particular company's situation. Sometimes it is part of a broader movement covering the whole market or a given sector. Similarly, a rise in the index does not yet mean that all companies are doing well in terms of results, debt or the quality of the business. The index shows the behaviour of a group of firms as a whole, while assessing a particular business requires separate analysis.

What an index does not show and what is worth paying attention to

A stock index helps you see a broader picture of the market, but it does not show the full situation of every company. It can happen that the index itself rises, while some of the firms it includes have weaker financial results, lower sales or rising debt. It can also be the other way around. The index falls, although some companies still develop well and keep a solid financial situation. For this reason the movement of the index alone is not enough to assess the condition of a particular business.

The way a given index is calculated also matters. In many cases the largest companies have a greater influence on its result. This means that a few very large firms can clearly lift the whole index, even if many smaller businesses are not rising or are even losing value. When you look only at the index itself, you may therefore get the impression that the situation of the whole market is very good, although in reality the improvement concerns mainly a small group of the largest companies.

An index also does not answer the question of whether shares are expensive or cheap. It only shows how the value of a selected group of companies changes. It does not say whether share prices are high in relation to the firm's profits, its assets, the level of debt or the pace of development. It also does not show whether a given company has a stable business model, a good competitive position or sensibly managed capital. Such conclusions require a separate look at the financial data and the activity of the business.

For a beginner Elegant Investor, therefore, one thing is most important. An index is worth treating as a reference point, not as a full assessment of the market and companies. It helps you understand the direction of changes, but it does not replace analysis when you want to better assess a particular firm or understand more broadly what is happening on the stock market.

How to start using stock indices

At the start of learning about the stock market there is no need to watch a large number of indices. A few basic ones are enough, which help you understand how different parts of the market behave. It is good to start with one broad index of your home market, one index of the largest companies on that market and one or two main US indices. Such a set lets you see the difference between the local and the foreign market, and between the broad market and the group of the largest firms.

It is also worth looking at indices over a longer period, not only through the lens of a single day. A one-day rise or fall may result from a momentary reaction of investors to economic data, a central bank's decision or an important political event. Observing how an index behaves over months and years says much more. Such a horizon better shows the direction of changes and helps tell short-lived fluctuations apart from a broader movement of the market.

It is also useful to compare the chart of a chosen company with the chart of the relevant index. Thanks to this it is easier to assess whether a change in the price concerns mainly that one firm, or fits into a broader movement of the market or sector. Such a comparison is not yet enough to assess the quality of a company, its financial results or its valuation, but it shows well whether the behaviour of the price is isolated or similar to what is happening more broadly on the market.

What to remember about stock indices

Stock indices show the behaviour of a group of companies and help assess what is happening on the stock market in a broader view. Thanks to them it is easier to tell the situation of one firm apart from a movement covering a larger part of the market, a chosen sector or the largest companies of a given country. This is exactly why indices are one of the basic points of reference in market analyses and in learning about investing.

The index alone, however, is not enough to assess a particular company. It does not show the quality of the business, the level of debt, profitability or whether the share price is justified by the financial data. It does, however, help you properly set this information in a broader context. And this matters a great deal when you want to better understand the stock market and draw more accurate conclusions from the changes you observe.

Sources:

S&P Dow Jones Indices (information on the S&P 500, Dow Jones and index methodology, https://www.spglobal.com/spdji), Nasdaq (information on the Nasdaq Composite and listed companies, https://www.nasdaq.com), Deutsche Börse (information on the DAX, https://www.deutsche-boerse.com), Euronext (information on the CAC 40 and European indices, https://www.euronext.com), London Stock Exchange Group (information on the FTSE 100, https://www.lseg.com), Nikkei (information on the Nikkei 225, https://www.nikkei.com), Hang Seng Indexes (information on the Hang Seng, https://www.hsi.com.hk), Shanghai Stock Exchange (information on the Shanghai Composite, https://www.sse.com.cn), MSCI (information on the MSCI World and global indices, https://www.msci.com), FTSE Russell (information on the FTSE All-World and Russell 2000, https://www.ftserussell.com), CFA Institute (investor education on indices and benchmarks, https://www.cfainstitute.org), Investopedia (definitions of stock indices, market capitalisation and liquidity, https://www.investopedia.com), World Federation of Exchanges (information on stock exchanges worldwide, https://www.world-exchanges.org)

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