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What should a stock market index be ?

What do the ups and downs of an index mean ?
What is the basic idea in an index ?
What kind of averaging is done for calculation of an index ?
Why are indexes important ?
What kinds of indexes exist ?

What should a stock market index be ?
A stock market index should capture the behaviour of the overall equity market. Movements of the index should represent the returns obtained by "typical" portfolios in the country.

What do the ups and downs of an index mean ?
They reflect the changing expectations of the stock market about future dividends of India’s corporate sector. When the index goes up, it is because the stock market thinks that the prospective dividends in the future will be better than previously thought. When prospects of dividends in the future become pessimistic, the index drops. The ideal index gives us instant-to-instant readings about how the stock market perceives the future of India’s corporate sector.

What is the basic idea in an index ?
Every stock price moves for two possible reasons: news about the company (e.g. a product launch, or the closure of a factory, etc.) or news about the country (e.g. nuclear bombs, or a budget announcement, etc.). The job of an index is to purely capture the second part, the movements of the stock market as a whole (i.e. news about the country).

This is achieved by averaging. Each stock contains a mixture of these two elements – stock news and index news. When we take an average of return on many stocks, the individual stock news tends to cancel out. On any one day, there would be good stock-specific news for a few companies and bad stock-specific news for others. In a good index, these will cancel out, and the only thing left will be news that is common to all stocks. That is what the index will capture.

What kind of averaging is done for calculation of an index ?
For technical reasons, it turns out that the correct method of averaging is to take a weighted average, and give each stock a weight proportional to its market capitalisation.

Why are indexes important ?
Traditionally, indexes have been used as information sources. By looking at an index we know how the market is faring. This information aspect also figures in myriad applications of stock market indexes in economic research. This is particularly valuable when an index reflects highly uptodate information (a central issue which is discussed in detail ahead) and the portfolio of an investor contains illiquid securities – in this case, the index is a lead indicator of how the overall portfolio will fare.

In recent years, indexes have come to the fore owing to direct applications in finance, in the form of index funds and index derivatives. Index funds are funds which passively ‘invest in the index’. Index derivatives allow people to cheaply alter their risk exposure to an index (this is called hedging) and to implement forecasts about index movements (this is called speculation). Hedging using index derivatives has become a central par of risk management in the modern economy. These applications are now a multi-trillion dollar industry worldwide, and they are critically linked up to market indexes.

Finally, indexes serve as a benchmark for measuring the performance of fund managers.

What kinds of indexes exist ?
The most important type of market index is the broad-market index. In most countries, a single major index dominates benchmarking, index derivatives and research applications. In addition, more specialised indexes often find interesting applications. In India, we have seen situations where a dedicated industry fund uses an industry index as a benchmark. In India, where clear categories of ownership groups exist, it becomes interesting to examine the performance of classes of companies sorted by ownership group.