An economic concept that is often used for changes in the securities market.

Author: Zezhao Fang
Zezhao Fang
Zezhao Fang
I hold a degree in Statistics from the University of Waterloo. As a graduate, my academic focus has equipped me with strong analytical and quantitative skills. While I currently do not have a specific profession or work experience, my education has honed my abilities in statistical analysis, data interpretation, and problem-solving. I am well-versed in various statistical methods and techniques, making me adept at deriving meaningful insights from data.
Reviewed By: Adin Lykken
Adin Lykken
Adin Lykken
Consulting | Private Equity

Currently, Adin is an associate at Berkshire Partners, an $16B middle-market private equity fund. Prior to joining Berkshire Partners, Adin worked for just over three years at The Boston Consulting Group as an associate and consultant and previously interned for the Federal Reserve Board and the U.S. Senate.

Adin graduated from Yale University, Magna Cum Claude, with a Bachelor of Arts Degree in Economics.

Last Updated:October 26, 2023

What Is an Index?

The index is an economic concept. In terms of its definition, any relative number formed by comparing two values can be called an indicator. 

In a narrow sense, an indicator is a special relative number used to measure the combined changes of several items in different contexts.

Statistics are designed and calculated from the prices of certain sampled stocks, electronic spots, or bonds to measure price fluctuations in the stock market, electronic spot, or bond market. Electronic Spot House has an introduction to this. 

For example, common stock price indices in the United States include the Dow Jones Industrial Average and the Stamp 500 Corporate indicator. The most famous bond price indices are the Salomon Brothers Bond and the Sheason-Lehman Bond Index.

A stock indicator is a stock price indicator. It is compiled by a stock exchange or financial services institution. It is an indicator figure used to show the movement of the stock market for reference.

Since stock prices fluctuate, investors are necessarily exposed to market price risk. 

While it is easy for investors to understand the price changes of a specific stock, it is not easy and tedious to understand the price changes of multiple stocks one by one. 

To accommodate this situation and need, some financial services institutions have taken advantage of their business knowledge and familiarity with the market to compile stock price indices. Then, they publish it publicly as an indicator of market price movements. 

Accordingly, investors can test the effectiveness of their investment and use it to predict the movement of the stock market. 

At the same time, the press, company owners, and even political leaders use this as a reference indicator to observe and predict the socio-political and economic development situation.

Financial indices measure the general price level and trends in the financial market. They are a sensitive signal of a country or region's political and economic development. 

Many indices, including composite and disaggregated indices, reflect different industries. In addition, the same aggregate indicator used for comparison contains two or more influencing factors. 

However, when calculating the composite indicator, only one of the factors is observed to change. Therefore, the other influencing factors are fixed to exclude the influence of their changes so that the total indicator is compiled, called a composite indicator.

Role of An Index

The purpose of the indicator is to help investors understand the overall situation of the entire market operation and the direction of the general trend development. 

Technical and financial indicators are used to analyze the indicator's performance and help investors make decisions accordingly. 

In addition, there is a sector indicator to reflect the overall operation of a sector. When the sector index rises, most of the individual stocks in the sector rise.

In brief, the role of the indicator can be summarized as follows:

  1. A comprehensive reflection of the direction and extent of stock price movements in a given stock market over a certain period.
  2. It provides information for investors and analysts to study and judge stock market dynamics and facilitates the analysis of the general trend of the stock market.
  3. It provides a "benchmark return" for stock market investments as a yardstick for evaluating investment performance.
  4. It serves as the basis for indicator derivatives and other financial innovations.

A stock market index is a reference indicator of stock market movements compiled by a stock exchange or financial services institution. Investors can test the effectiveness of their investments and forecast the stock market movement. 

At the same time, the press, company owners, and even political leaders also use it as a reference indicator to observe and predict socio-political and economic development.

Because of the complexity of calculating stock indices, there are many different kinds of stock simultaneously. Therefore, people often select several representative sample stocks from the listed stocks and calculate the price average or indicator of these sample stocks. 

It is used to indicate the general trend of stock prices and the extent of increase or decrease of the whole market.

Calculating the index

While calculating, three factors are considered. 

  1. Sampling: A small number of representative constituent stocks are selected from many stocks. 
  2. Weighing: A weighted average by unit price, total value, or an unweighted average. 
  3. The calculation procedure: Calculate the arithmetic mean, geometric mean, or balance between price and total value.

Due to the wide variety of listed stocks, calculating the price average or indicator of all listed stocks is arduous and complex. Therefore, people often select a representative sample of stocks from the listed stocks and calculate the price averages or indices of these sample stocks. 

This indicates the general trend of stock prices and the extent of increase or decrease in the whole market.

The following four points are often considered when calculating the stock price average or indicator.

  1. The sample stocks must be typical and common. For this reason, the sample selection should consider industry distribution, market influence, stock rank, and an appropriate number of factors.
  2. The calculation method should be highly adaptable and able to make corresponding adjustments or corrections to the ever-changing stock market sentiment so that the stock indicator or average has good sensitivity.
  3. To have a scientific basis for calculation and means. The caliber of the calculation basis must be unified, generally based on the closing price, but with the increase in the frequency of calculation, some of the hourly price or even shorter time price calculation.
  4. The base period should be well-balanced and representative.

A stock index is a weighted average of the prices of a representative group of stocks. Of course, the selection of stocks and the calculation method are different for each indicator. But, the constituents of it will have a certain uniform characteristic. 

For example, from the perspective of market capitalization, the fact that they are not all relatively large, once the indicator is compiled, its future trend changes also reflect the overall performance of stocks with this characteristic.

It allows investors to visualize the performance of a certain type of asset as a whole very easily. And because there is more than one component stock or security selected for the indicator itself. And it is calculated by averaging the various weighting methods. 

So, the indicator represents the average price movement of a specific type of securities or securities with certain common characteristics. There are many different kinds of indices. 

For example, stock indices, bond indices, gold indices, crude oil indices, etc., are commonly seen. However, some indices, such as the Baltic Dry, are less commonly seen. 

In short, each indicator represents an average price trend, and it can be a beacon of light in the middle of the market investment.

Stock Price Indices and Market Illusions

Stock price indices are statistical relativities of stock prices compiled to measure and reflect the overall price level of the stock market and its trends.

The average price or market value of stocks in the reporting period is compared with the average price or market value of stocks in the selected base period, and the ratio of the two is multiplied by the indicator value of the base period.

This is the stock price indicator for that reporting period. 

When the stock price indicator rises, it indicates that the average price level of the stock has increased. Conversely, when the stock price indicator falls, the average price level of stocks falls. 

It is a barometer that reflects the social, political, and economic changes in the country (or region) where the market is located.

If a bull market causes a stock price to deviate from its investment value, the stockholders' profits are virtual, and some of them are based on the losses of others. In a short-term bull market, the stock market may create an illusion. 

In a short-term bull market, the stock market may create an illusion that everyone is a profitable shareholder when such profits are virtual. This is because the overall value of a stock is calculated by the price at which some stocks are traded. 

When a stock is traded at a higher price, the market value of some of the untraded stocks will be calculated at the traded price. The result is that the book value of all stockholders holding that stock is higher. 

For example, more than 70% of state shares or legal person shares in listed companies are not listed in circulation. Still, some people often calculate the value of state assets by the stock's market price. 

When the stock price rises, it is believed that the value of state assets has increased. 

However, if all shares of listed companies are circulated, due to the sharp increase in the supply of stocks, it would be difficult to speculate the price of stocks to such a high level as today's stock market. 

So the profit in the stock market cannot be calculated by the transaction price of others but only by the transaction price realized at the time of selling. 

In addition, the profit of certain stockholders is predicated on the loss of other stockholders when the stock price is out of its investment value. For example, the annual after-tax profit of a stock is $0.1, and the current one-year savings rate is 10%. 

Therefore, the theoretical price of this stock should be $1. 

When some stockholders speculate its price to deviate from its investment value, say from $1 to $5, the stockholder who bought it for $1 and sold it for $5 made a profit of $4, but the stockholder who bought it for $5 made a loss of $4. 

This is because the actual return on the stock is only equivalent to a $1 savings deposit. So in stock speculation, the latter usually returns the first to buy, and the new stockholders return the old.

Types of indicators

In a broad sense, all relative numbers that reflect the overall quantitative changes of a phenomenon are exponents. In a narrower sense, indices reflect the overall quantitative changes of complex phenomena.

For example, in the middle of the 18th century, due to the massive flow of gold and silver to Europe, prices in Europe soared and caused social unrest, so the need to reflect price changes arose, which is the root of the price indicator. 

Some indices, such as consumer price and cost of living, are related to people's daily lives. 

Other indices, such as the price indicator of production materials and the stock price indicator, directly impact people's investment activities and become the barometer of the social economy.

As a comparative statistical indicator, the indicator has the form of a relative number, usually expressed as a percentage. If the level (base) used as a benchmark for comparison is considered 100, the level of the phenomenon to be examined is equivalent to the base. 

For example, if the national retail price indicator for a given year is known to be 105%, and if the general price level of the base year (usually the previous year) is considered to be 100%, the national price level for that year is equivalent to 105% of the base year. 

Or, prices in the current year have increased by 5 percent.

By its comparative nature, the indicator usually compares the levels of phenomena at different times and indicates how they move in time (dynamics). 

In addition, the indicator can compare the level of the phenomenon in different spaces (e.g., countries, regions, sectors, firms, etc.). 

Or, it is the comparison of the actual level of the phenomenon with the planned (planned or targeted) level, which can be seen as an extension of the dynamic comparative indicator approach. As you can see, indices have a wide application in economic analysis.

The indicator can be generally classified based on the following three criteria.

1. There are generalized indices and narrow indices.

The broad indicator refers to all relative numbers, i.e., the numbers reflecting the overall number of simple phenomena or the number of complex phenomena changes.

The narrow indicator refers to the relative number reflecting the overall quantity change of complex phenomena that cannot be directly added. Therefore, the narrow indicator is the main aspect of indicator analysis.

2. According to the range of objects reflected by the indicator, it is divided into.

  • Individual: It is a relative number reflecting the change in the number of individual phenomena (i.e., the total of simple phenomena).
  • Total: It is the relative number reflecting the change in the quantity of all phenomena (i.e., complex phenomena in general). 

It is divided into composite and average indicators according to the different calculation methods and formulas.

3. The indices are divided into quantitative and qualitative indices according to the nature of the indicators they reflect.

Quantitative indexes are assessment indexes that can be defined quantitatively accurately, measured precisely, and set performance targets. 

In the quantitative evaluation system, the evaluation benchmark value of each index is the evaluation benchmark to measure whether it meets the basic requirements of production.

Qualitative indicators are evaluation indicators that cannot be directly quantified but need to be quantified through other means. 

The disadvantage is that it is easy to bring in the assessor's subjective factors, and the index's differentiation and reliability are poor, which inevitably affects the objectivity of the assessment.

In the stock market, an indicator is a comprehensive indicator used to measure the overall volatility and prosperity of stock market transactions, which is an important basis for investors to make investment decisions.

Index FAQs

Researched and authored by Zezhao Fang | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

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