“The S&P 500 closes at 3.800 points”, this is a well-known end of radio news. But what exactly do these “points” represent? Short lesson of stock indices.
As we wrote in a previous blog, a stock market index is a numerical measure allowing an investor to evaluate in a simple way the performance of a specific set of financial instruments, often shares.
Since its interest is simplicity, the index is generally free from the monetary value of its constituents. It is therefore a virtual measurement whose absolute value has no other interest than to serve as a basis for calculation: only the difference observed during a period is important.
Let's say that the S&P 500 closes on a given day at 3.800 points, the day before at 3.715. The relative variation of the index from one day to the next is therefore (3.800-3.715)/3.715= 2,3%. This data allows investors to easily judge the profitability of their investments, the evolution of this profitability, and allows it to be compared to the profitability of other investments.
The variations of an index are expressed in points and correspond to the weighted average performance of the prices of the shares that make up this index. Each company included in the index therefore has a weight which generally derives from its market capitalization, i.e. the total value of its outstanding shares. Thus, the greater the capitalization of a company, the more the performance of this company will weigh on the evolution of the index.
Why is the Nasdaq currently measured at more than 10.000 points and the Bel 20 at only 3.000? Several elements play on these “point levels”: the date of creation of the index first – 1971 for the first and 1990 for the second – and the base value of the index. Thus, when it was created, the Nasdaq was worth 100 points while the Bel 20 was worth 1.000. It therefore makes no sense to compare the point value of one index and another.
Unlike most market-cap-weighted stock indices, a few rare indices are price-weighted. In this case, the value of the index is equal to the sum of the prices of the shares that constitute it. This is the method used by the Dow Jones Industrial Average, the very first index created in 1885, and by the Nikkei 225. These indices are therefore expressed in dollars for the first and in yen for the second.
Finally, as explained above, remember that an index is an indicator, not an investment product. But you can buy financial products that replicate indices: these are index funds (ETFs) or trackers. The stock market index will then serve as a compass for the ETF manager.