How Indices Broaden Our View

"This company looks cheap, that company looks cheap, but the overall economy could completely screw it up. The key is to wait. Sometimes the hardest thing to do is to do nothing."

-David Tepper

Can a single stock tell you the story of an entire industry or economy? Probably not. A stock generally reflects how a single company is behaving compared to other related companies. So how do we broaden our viewpoint to understand the broader market’s behavior? Instead of analyzing each stock individually, we build a cross-section of an entire economy by combining stocks to form indices.

Broadening the Viewpoint

Far from being an abstract idea, indices are an excellent way to broadly characterize and visualize market trends over time, while taking a broader view of an economy and its general level of activity. Instead of reflecting the performance of a single company, they demonstrate the performance of a group of companies simultaneously. You are probably already familiar with the most renowned indices because they are commonly used by news outlets to describe overall stock market performance.

Major benchmarks like the world-famous Dow Jones Industrial Average, the S&P 500, FTSE 100, DAX 30, and more are globally recognized indices that give us valuable information about how investors characterize economic activity at a given point in time. Because these major indices represent many companies simultaneously, they help us build a more comprehensive view about areas of the economy and whether they are outperforming or underperforming other comparable benchmarks.

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A Glimpse into the Future

Stocks are priced on a forward-looking basis, meaning that we price them according to our expectations of how a company will either grow or shrink in the future. When events like corporate earnings, breaking news, dividends, or other important announcements unfold, investors immediately react to all the available public information, impacting share prices accordingly. This means they make a buy or sell determination based on this new information and how it might impact future performance.

Stock indices are useful barometers for where an economy is heading simply because we price stocks based on future expectations. Unlike certain economic indicators like gross domestic product (GDP) or employment – which are measurements of past economic performance and therefore lagging indicators of current activity – indices are uniquely positioned to give us insights about future performance. When companies provide their forecasts about revenues, we can form a better idea of how they think future performance may progress.

Indices, because they are composed of many stocks, present us with a clear picture of what investors think about the entire economy. Indices generally represent the largest stocks from each sector of the economy. Instead of just representing technology stocks, indices are a combination of industrial stocks, retail stocks, transportation stocks, and more, providing us with a broader viewpoint.

How are Indices Composed?

Indices may be global (S&P 100), regional (Stoxx 50), national (Dow Jones Industrial Average). Depending on the index, the value may be calculated according to several different methods. Some are price-weighted, meaning that only price movements in the components influence the index valuation (like the Dow Jones Industrial Average), whereas others are capitalization-weighted, meaning that the size of the component companies influences their weighting in the index.

For instance, the S&P 500 is composed of the 500 largest US corporations by market capitalization. Market capitalization is defined as the price of shares multiplied by the number of shares outstanding. Over time, companies are added or subtracted based on how they perform, with those companies that fail to meet a certain minimum threshold of capitalization being replaced with more highly capitalized companies.

How do Indices Relate to Investing?

Global stock exchanges are home to thousands of publicly traded companies. Analyzing each company is a time-consuming process, involving countless research hours. Trying to pick which will outperform and which will underperform is a difficult task that even challenges professional investors. Luckily, indices can simplify the process and lower the costs instead of buying and selling each stock of an index individually.

One of the easier ways to diversify an investment portfolio and avoid the grueling task of analyzing every company is investing in indices. Although the returns may not be as high as those experienced by fast-growing companies, indices may also not weaken as much as the poorest performing stocks. Brokers like FXTM offer traders a range of indices to choose from. FXTM ECN Zero account holders seeking to broaden their portfolio exposure can pick from more than 10 popular global indices that reflect some of the largest global economies.

Putting Indices in Context

Index investing gives traders broad exposure to many sectors of the economy instead of narrowly investing funds in one sector versus another. While great stock pickers may come and go, the ease of investing in indices makes it easy to build a cost-effective, diversified portfolio that strips away much of the research and analysis needed to individually investigate each and every company.

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