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How are stock market indices calculated? | Why it鈥檚 important to know - YouTube
Channel: Investing with Perspective
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Hey everyone my name is dan and welcome
to my channel
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where i share with you my perspective on
investing
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in this video we're going to take it
back to the basics and this video is
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important especially if you're planning
to invest in
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index funds or etfs, why? well let's find
out
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we'll be exploring how indices are made
up and what kind of information they
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provide to you as an investor
and looking at how they're made up will
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mean that we'll touch on
how they're actually calculated which
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means there will be a little bit of maths
but i promise it won't be too
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overwhelming okay
to start off we'll first talk about the
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naming convention
of an index the name of abbreviation
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itself
is pretty straightforward but for most
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indices there will be a number
following the abbreviation which isn't
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just a random number
let's take one of the most popular
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indices for example
the S&P 500, this index tracks
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500 large companies listed in the US and
these companies have gone through
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a selection criteria in order to be
listed as one of the 500
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the committee responsible for the
selection will take into account
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the company's market capitalization
,liquidity
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sector classification, company's
financial viability and more
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so it isn't as simple as just picking
the 500 largest companies by market cap
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and as an investor you should really try
to understand
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what exactly these indices are tracking
simply because there are other indices
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such as the S&P 400 which tracks
companies with a mid-sized
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capitalization and also the S&P 600
tracking small market cap companies
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sometimes it can be confusing because
not all indices follow the same set of
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rules
for example the S&P 600 obviously does
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not track the 600 largest companies in
the US
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in most people's views the S&P 500 is
the most widely used
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and followed for the reason that it is
the most representative
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of the US stock market out of all the S&P indices, however, for some indices
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like the Dow Jones Industrial Average
there isn't a number following the name
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of that index
the Dow tracks only 30 large companies
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listed in the us
and also has its own selection criteria
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the Dow is just as popular
as the S&P 500 but it has been
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criticized
for not being representative of the US
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market as it only has 30 companies
the other big difference is that the Dow
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Jones uses a different calculation
method
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to the S&P 500 and this brings me to my
second point
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most indices are calculated using the
value-weighted method
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or market-cap weighted method, this
method basically uses the market
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capitalization of each company in the
index to allocate
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their individual weightings, we know that
the market cap of a company is the
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mathematical product
of its outstanding shares and its
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current share price
so to get market cap just multiply the
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number of outstanding shares
by the current share price, then we take
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the market cap
of each company and divide it by the
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total market cap
which is all the companies added
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together to get the weighting for each
stock
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this weighting basically represents how
much of an influence
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it has on the index, so the logic is that
the stocks with
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bigger market caps exert a greater
influence
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on the index, in other words it carries
more weight
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let's check out the S&P 500 components
for example
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here we can see that the top five are
tech
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companies taking up more than 20 of the
overall index
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and this means a 1% increase in
Intel for example
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will not be the same as a 1%
increase in Microsoft
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as Microsoft has about 5 times the
weighting
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of Intel's and if you think about it in
real terms
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this weighting kind of makes sense
because larger companies
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employ more people, have higher output, productivity and have more financial
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impact
on the economy in general, this is
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probably the most
common calculation method used by
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indices around the world,
some other examples the Nasdaq composite
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FTSE 100 ASX 200
and NZX 50, on the other hand
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there are indices that use the price-weighted method
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like the Dow Jones and the Nikkei 225
the idea of this method is very
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different and it's to have the
weightings
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assigned based on the price of the stock
so the weighting for each stock is the
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price divided by the total price of all
the stocks in that index
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so naturally the stocks with the higher
prices will have more influence
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on the index, kind of a weird method
though right
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so in the example of Dow Jones, you can
see that the stock with the highest
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price
gets assigned the biggest weighting
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currently that stock is Apple
and if you look at the top five holdings
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they account for almost
40% of the index so is this the
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kind of diversification you want
so what about stock splits then, for
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every index there's something called the
divisor
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which effectively determines the final
calculation of the index
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with a stock split the divisor will also
change as the index will
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otherwise be skewed, because the company
hasn't really lost value
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it just has more shares at a lower price
after the split and all these indices
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that use either of those methods
have their own divisor to adjust for
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factors that may affect
the index this is just a way to keep the
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index neutral
of external factors, now when you see
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those indices
index funds or etfs again i hope they
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won't appear to you as
just another index, there are so many of
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them
out there and sometimes it's a bit
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overwhelming trying to pick one
without understanding the mechanics
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behind them
but we know that from a lot of past
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studies whether you pick the Dow
or the S&P 500 the returns
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seem to be more or less the same over a
long period of time of course
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but we can't forget that no two years
are the same
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and so in the short term you may
actually see
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one index lagging behind the other, so
for example at the end of 2019
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Boeing was still the biggest component
in the Dow taking up around 8%
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of the index despite attracting a lot of
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negativity
around its 737 max aircrafts
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this negativity was then worsened by the
airline industry taking a massive hit
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because of the virus and we all know how
much the Dow
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plunged during this time, my point is
Boeing being the biggest component
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may have caused the Dow to drop more
than expected
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than if the biggest component was apple
instead
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so if we look at the year-to-date chart
comparing
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the S&P and the Dow we see that the Dow
was actually lagging a bit behind so far
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this year
and that is obviously one of the
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downsides of the Dow being a price-weighted index
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that there is a greater reliance on the
stocks with higher prices
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to drive the index, this just goes to
show that it is important to understand
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where you're putting your money
rather than blindly picking an index
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that you think will just go up
like the rest of the indices out there
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and then getting confused as to why
you're lagging behind
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the broader market i'm not telling you
that one index is definitely better than
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the other
but under different circumstances and
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situations
one may perform better than the other
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again picking an index fund or an etf
will depend on your risk appetite
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and what kind of diversification is
appropriate for your investment
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objectives, so the next time you want to
invest in an index fund or an etf
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i'd encourage you to do some background
research on how the fund is composed
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what the top holdings are in the fund
and whether or not those stock holdings
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are prone to big changes in the future
any questions feel free to leave a
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comment
down below and i'll reply to it as soon
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as i can, thanks for watching
and have a great day
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