What is a Stock Market Index?
A stock market index is a statistical measure which shows how the stock market is changing. An index is an aggregation of stocks selected from stocks already listed on a particular exchange.
The criteria of stock selection could be the type of industry, market capitalization or the size of the company. The value of the stock market index is computed using values of the underlying stocks. Any change taking place in the underlying stock prices impact the overall value of the index. If the prices of most of the underlying securities rise, then the index will rise and vice-versa.
In this way, a stock index reflects overall market sentiment and direction of price movements of products in the financial, commodities or any other markets.
Share Indices -Kenya
How to compute a share Index
Stock market indices are developed by aggregating similar stocks based on market capitalization, industry or company size.
Once the stocks are selected, the index value is computed. The stocks selected have different prices, therefore, a price change in one stock would not be proportionately equal to the price change in another. For this reason, the value of an index cannot be computed as a simple sum of the prices of all the stocks.
Since an index value cannot be computed using a simple sum, assigning weights to stocks comes into play. Each stock in the index is assigned a particular weightage based on its market capitalization or price. The weight represents the extent of the impact that the stock’s price change has on the value of the index.
The two most commonly used stock market indices are as follows:
Market capitalization refers to the total market value of the stock of a company. It is calculated by multiplying the total number of outstanding stocks floated by the company with the share price of a stock. It, therefore, considers both the price as well as the size of the stock. In an index which uses market-cap weightage, the stocks are assigned weightage based on their market capitalization as compared to the total market capitalization of the index.
It is important to note that market capitalization of a stock changes every day with the fluctuation in its price. Due to this reason, weightage of the stock would change daily. But usually such a change is marginal in nature. Moreover, the companies with higher market-caps get more importance in this method.
The Index value is computed based on the stock price of a company rather than the market capitalization. Thus, the stocks which have higher prices receive greater weightages in the index as compared to the stocks which have lower prices.