What is an index?

Strictly speaking, an index is like a barometer showing whether a particular market is moving up or down. An example of this would be the DAX 40 index which includes the 40 largest public limited companies in Germany. If you want to know now how the German stock market is developing, you can read this immediately in the DAX. By merging the shares of the largest and most successful companies into a basket of shares (=index), investors were able to share in the success on the one hand, and on the other hand, they gained an overview of the general economy in their country as a whole.

In particular, investors are closely monitoring the development of major indices such as DAX and Dow Jones, because they can quickly and easily see the current overall situation in the stock market world. If, for example, the DAX falls over a longer period of time, it is said that stock markets, and thus the economy, are currently in poor shape.

Calculating an index is relatively complex. Think of the index as a basket of securities with a number of stocks. However, not all stocks have the same weight. This is because there are smaller and larger companies. The most common method of calculating weighting is according to market capitalization. This means that the largest company receives the largest share of the index.

For example, some companies in the DAX are real heavyweights, such as Deutsche Telekom. Others are slightly smaller than Bayer or SAP. Logically, however, all companies represented in the DAX are among the largest and best-known in Germany.

Such stocks are called standard values, large caps (due to their large market capitalization), or blue chips. This term comes from the casino – blue chips have the highest value in roulette.

In general, shares can be divided into several categories in terms of size:

  • Large Caps
  • Mid-sized companies (Mid Caps)
  • Small Caps
  • Smallest public limited companies (Micro Caps)

The default values are summarized in the DAX. The medium-sized public limited companies are represented by the MDAX and the small public limited companies are included in the SDAX.

What is an indication?

Indices also play an important role in stock exchange trading. They indicate the direction in which the selected market is currently moving. For the participants,  these indications are an important basis for assessing the general market situation and for investment decisions.

In fact, the majority of indices belong to the stock indices, i.e. they refer to stock markets. The best-known German stock index is the DAX, in the European Union it is called the most famous index  Euro Stoxx, in the United States there are the Dow Jones Index, the Nasdaq, and the S&P 500. In Asia, the best-known are Japan’s Nikkei, which is held by the Tokyo Stock Exchange, the Shanghai Composite of China,  and Hang Seng of Hong Kong, which originally operated separately from China. Indices are calculated not only for stock markets but also for all financial and commodity markets on the global stock exchanges. Therefore, bond or commodity indices also exist. It is also logical to differentiate according to other criteria. For example, indexes can be created for states and districts, as well as specific industry or industries.

How are indexes calculated?

First, keep in mind that an index is defined by the mean of a set of values. There are different ways to calculate the average. A distinction is made:

  • Capitalization-weighted indices: the individual values in the index are weighted according to their market capitalization. Stocks with a high market capitalization have a higher weight than those with a low. Examples: DAX, S&P 500, SSEC;
  • Price-weighted indices: each value in the index is equally taken into account. If an index consists of 30 shares, each share with a price value of 30 is included in the calculation. The price (price) thus determines the index weight. Examples: Dow Jones Index, Nikkei Index;
  • Balanced indices: each value in the index has the same weight. For an index with 30 stocks, each index value has a weight of 1/30 = 3%. The balance is only valid on the balance sheet date. When prices change, the weights change over time. Then a rebalancing is required.

Price index or performance index

Indices can be determined as price indices or performance indices. However, a performance index only makes sense for market values with interim income (dividends, interest). The price index actually only reflects the average price; in the performance index, interim gains are assumed to be reinvested in the index values. It therefore does not show the average price development, but the average investment success that would have been achieved if the index values had been continuously invested.

While the Dow Jones index can be described as a classic price index, the DAX is calculated as both a performance index and a price index. 

Index-related financial products

Since the 1990s, financial products that enable index-based investments have been very popular. This applies in particular to ETFs (exchange-traded index funds) which have been authorized in Germany since 2000. These funds are very cost-effective due to their passive investment strategy and offer an advantageous risk-return ratio. They also correspond to the financial theoretical notions of “proper investing”. Index certificates take a similar approach. Classic funds also work with indices. Here, an index often serves as a benchmark against which the success of fund management is measured.

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