Personal Finance
Lesson 18
3 min

What is an index?

The construction of an index is fundamentally based on a number of securities representing a certain market that are grouped in a collection to track their price performance. 

  • An index is a measure to indicate a change in the size of values such as the prices of securities over time

  • Indices are used to track the price performance of securities grouped in a hypothetical portfolio representing a certain market or market segment

  • These securities may represent major titles in the stock market of a nation, an industry, or a market or a segment of a stock exchange

  • Currencies, funds, commodities and bonds may also be contained in an index

  • Dow Jones, S&P 500, DAX and Nikkei are the most well-known indices

In this lesson, you will learn about the basics of indices.

As we are progressing towards more advanced subjects in the Personal Finance section of the Bitpanda Academy, you are going to discover which ways certain investment vehicles are combined in to enhance profitability and to diminish risks.

Evaluating price development of securities

Remember what you read in lesson 16: if several financial assets like stocks, commodities, currencies, bonds and other securities are organised and grouped together based on certain criteria, this is called a “portfolio”. Such criteria may be a certain market, a market segment or an asset class. Furthermore, investors also refer to all their assets as their “portfolio” - generally, the term indicates a collection of securities. 

To evaluate economic developments and trends for their strategy, investors need convenient tools to track the market performance of select companies and their issued securities. In certain cases, it would be much too time-consuming to analyse the underlying factors of every single publicly listed company in a market or market segment. 

Famous indices

For easier, yet very precise market analysis, so-called indices (the plural of the word “index”) are used to monitor price developments. An index provides investors with a single measurement that summarises the open and close prices of a hypothetical portfolio of assets. 

Indices are convenient tools to track the market performance of selected companies.

The oldest index in the world, the Dow Jones Industrial Average (DJIA), was established in 1896 and originally tracked twelve companies. Another well-known US index is the S&P 500 (Standard & Poor’s 500) which holds 500 of the largest US companies. The German index DAX, and the Nikkei 225, Japan’s leading index, are also benchmark indices. An example of an index mentioned in financial news is: “The Dow Jones closed higher and posted small gains of 0.04%.”

What is an index measure?

When you hear on the news that stock market prices are going up or down, this trend does not refer to a single stock. Rather, the trend refers to a measurement of a hypothetical portfolio - an index - that represents one segment of the financial markets. 

Investors use market indices as a tool to assess developments such as market movements and much more. 

The value of an index is calculated - or “weighted” - based on the prices of its securities or many other factors, such as market capitalisation (market cap). Investors use market indices as a tool to assess developments such as market movements and much more.

 
 
 
 

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How is an index used?

As an investor, you want to watch the performance of indices that are relevant to the assets you are invested in. Tracking an index may provide you with valuable information of how your portfolio is performing as indices provide a benchmark to compare your portfolio to. 

Investors can’t invest directly in an index as it is a hypothetical basket of securities. They invest in index funds such as ETFs or mutual funds mimicking an index. Exchange-traded funds (ETFs) track a certain index and directly replicate its performance, meaning the fund will develop like the index, either in an advantageous or disadvantageous way. 

To further your knowledge on the various types of securities, read our next article on bonds.

FURTHER READING 

BOOKS

  • Ellis, Charles D. - The Index Revolution: Why Investors Should Join It Now

  • Malkiel, Burton G. - A Random Walk Down Wall Street 

Capitalisation-weighted index

With the rise of index funds, who watches the companies?

Why an index fund is so hard to beat

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