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Definition: Market Index
A market index is a metric that tracks the performance of a group of stocks; in other words it measures the relative value of a group of stocks. The index can be designed to either indicate or track the overall performance of the market or a particular sector.
The famous indices are the Dow Jones (one of the oldest indexes in the world), S&P500, NASDAQ, DAX, Nikkie, Hang Seng, Sensex and Nifty.
The market index is majorly used by investors and financial advisors to analyse the market and gauge the return on investment. It helps the investor to get the overall trend of the market. So if you have invested in individual stocks or mutual funds, then one should keep a check on the relative market index. If your investments continuously lag behind the index, then it may be a good time to review your investment strategy.
There are two types of indices – global and national. As the name suggests, a global index constitutes of typically large companies world-wide i.e. irrespective of the where they are traded (S&P100 Global). National index indicates the performance of a stock market of a particular nation or economy (Nifty – India).
The index is made up of securities and is composed by deciding which stocks to choose and which not to. The hard part making an index is choosing the relative weight of each company. Various methods are used to calculate the market index value:-
Price weighting: The price movement of each security affects the index value. The size of the company is ignored. Ex: Dow Jones.
Capitalization weighting: In contrast with the above method, the taken into consideration. Thus the index value changes with even small price movement of the large company. Ex: Hang Seng.
Equal-weighting: As the name suggests, each security is assigned an equal value. Ex: Barron’s 400.
It is important to note that one cannot invest in an index directly, but invests in the products that track them. One of the popular examples is the exchange traded funds. ETFs are similar to shares in way that it is possible to buy and sell them throughout the trading day based on their live prices. A diversified portfolio can be built in a cost-effective way by the use of ETFs.