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Trading in financial markets involves significant risk of loss which can exceed deposits and may not be suitable for all investors.
Before trading, please ensure that you fully understand the risks involved
Trading in financial markets involves significant risk of loss which can exceed deposits and may not be suitable for all investors. Before trading, please ensure that you fully understand the risks involved
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Tuesday, August 25, 2020

Indices: What is Index Investment?

by Century Financial in Brainy Bull

Indices: What is Index Investment?

What are Indices?

Indices are a measure of a section of shares in the stock market. Indices are created by combining the value of several stocks to create one aggregate value. Indices are either region-based or sector-based.

Types of major global Indices

Major financial indices include the Dow Jones Industrial Average, S&P 500, FTSE 100, CAC 40, and Dax 30. The Dow Jones Index, for example, represents 30 large publically-listed companies traded on the New York Stock Exchange. The FTSE100 index represents 100 companies listed on the London Stock Exchange with the highest market capitalization, while the S&P 500 represents a broad range of 500 US companies. The index itself represents the value of a group of stocks from one country and shows the overall, current, and historical performance of that stock index. There are many types of indices available to trade at spot price or through forward trading.

Categorization of Indices

Indices can be categorized by geographic location, industry sector, or company size. Some indices are categorized by the size of the companies they represent, such as the S&P SmallCap 600 and S&P Composite 1500. This helps provide investors with several trading opportunities. Businesses within an index must meet specific criteria. Companies within the S&P 500, for example, must have a certain market capitalization.

Every country’s stock exchange in the world has a benchmark stock index, and some have several indices. As it would be close to impossible to track every stock in every country, the correlation between global economic events and the price patterns of major indices is a key understanding for traders who want to participate in the fascinating indices markets. Economists, politicians, and analysts can use stock indices to understand how well the financial markets and companies in those markets are performing.

How are Stock Indices calculated?

Today, most stock indexes use a weighted average formula to determine the value of the index. Market-capitalization-weighted indexes give more weight to companies with higher market capitalizations. Both the S&P 500 and the Nasdaq Composite are market-cap weighted, and large companies like Apple and Microsoft have much greater weightings than the smaller companies that make up these indexes. Price-weighted indexes give more weight to companies with higher stock prices.

Example of a Stock Market calculation

For example, in a hypothetical index made up of three stocks with share prices of $70, $20, and $10, the $70 stock would make up 70% of the total index, regardless of the relative size of the company. The Dow Jones Industrials and Nikkei 225 is the most important example of a price-weighted index. A price-weighted index sums up the price per share for each stock included within it. The sum is then divided by a common divisor, usually the total number of stocks in the index.

Major world Indices

The FTSE 100 – Sometimes called the UK 100, represents the hundred biggest companies by market capital in the UK.

Dow Jones – Often referred to as US30, tracks the stock performance of the thirty biggest publicly-owned companies in the US.

DAX – Also known as the Germany 30, is made up of thirty major German companies.

NASDAQ 100 – The ‘US Tech 100,’ is a capitalization-weighted index made covering the hundred largest and most liquid technology companies in the US.

Nikkei 225 – Japan’s biggest price-weighted index is comprised of 225 of the country’s biggest companies.

CAC 40 – Better referred to as the France 40 is a capitalization-weighted measure of the 40 most significant stocks among the hundred largest market caps companies in France.

How do Indices work?

As an indicator or benchmark of the top-performing businesses in an industry, the value of an index is affected by the performance of its constituent companies. Benchmarking can be used to measure a fund or stock’s performance. Market indices will typically be used as a benchmark, as they can give a broad market view for comparison. Indices can help to track a market’s changes over time. An investor might use the S&P 500 as a benchmark to assess their own portfolio’s performance, for instance.

Indices with lower volatility are also available for trading, such as the S&P 500 Low Volatility Index. However, rising interest rates can negatively affect the performance of such indices. This is due to the characteristics of sectors usually linked to these strategies, such as utilities and staples. Investors would do well to note that low volatility indices have exposure to rising interest-rate risk.

Difference between Indices and Indexes

Indices are also known as indexes, so there is no real difference between the two. The word ‘index’ has two acceptable plural forms, which can cause some confusion. When it comes to trading, an index is the measure of several stocks to create one value. There are different ways that investors can capitalize on indices. Index funds are a type of mutual fund which incorporates stocks that follow or track the components of a market index.

Benefits of Index Fund

Advantages associated with an index fund are broad market exposure, low operating expenses, and low portfolio turnover. Portfolio turnover is a measure of how often assets within a fund are bought and sold by managers. This needs to be considered by investors because a high turnover rate will incur more transaction costs than a fund with a lower rate. That is, unless the new asset selection’s returns offset the added transaction costs they bring.

How Index investment works

Index investing is another method that allows investors to reproduce the performance of indices. This strategy replicates the movement of an index through the use of ETFs. The exchange-traded fund acts as an index tracking instrument. It is made up of the same stocks that comprise a particular index. The ETF closely monitors and shadows the underlying stock market index.

Investors can use index values to follow market trends and other developments, and it is also possible to purchase an indexed annuity, which is a life insurance product. Returns are linked to an index such as the S&P 500. This type of annuity produces gains based on a specified equity-based index. Because the annuity is fixed, capital is protected from market volatility.

Possible risks with trading Indices

Trading indices is considered by many to be a lower-risk strategy, as one is spreading their risk across an entire segment or sector, as opposed to a single stock. However, there are still risks involved. This is because one is trading a derivative instead of a physical asset. Here, a derivative is an instrument that obtains its value from the price of an underlying asset, such as an individual stock or stock index. The risk is that the movement of just one stock or security within the index could have a major impact on the value of the index.

Bottomline on investing in Indices

It’s important to do research prior to trading indices. Collecting news and analysis can help traders make better-informed decisions. It’s always a good practice to make use of risk management tools. Most trading platforms offer a range of risk management tools and resources to help traders protect their positions against sudden market moves.

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