6.2 Security Market Indices - 6.2 Security Market Indices Explained
Key Concepts
- Security Market Indices
- Index Construction
- Weighting Methods
- Rebalancing
- Benchmarking
Security Market Indices
Security Market Indices are statistical measures designed to represent the performance of a specific segment of the market. They are used to track the overall health of the market, compare individual securities, and serve as benchmarks for investment performance.
Example: The S&P 500 is a well-known index that represents the performance of 500 large-cap U.S. companies. Investors use the S&P 500 to gauge the performance of the broader U.S. stock market.
Index Construction
Index Construction involves selecting the securities to be included in the index and determining how they will be weighted. The selection criteria can vary widely, from market capitalization to sector representation.
Example: The Dow Jones Industrial Average (DJIA) includes 30 large, publicly-traded companies in the U.S. The selection is based on qualitative factors such as reputation and long-term growth.
Weighting Methods
Weighting Methods determine how much influence each security has on the index. Common methods include price-weighted, market-capitalization-weighted, and equal-weighted approaches.
Example: The DJIA is a price-weighted index, meaning that companies with higher stock prices have a greater impact on the index's performance. In contrast, the S&P 500 is market-capitalization-weighted, where larger companies have a more significant influence.
Rebalancing
Rebalancing involves adjusting the composition and weights of the index to maintain its intended characteristics. This process is typically done periodically, such as quarterly or annually, to reflect changes in the market.
Example: If a company in the S&P 500 experiences a significant drop in market capitalization, it may be replaced by a more representative company during the next rebalancing period.
Benchmarking
Benchmarking involves using an index as a standard against which the performance of a portfolio or individual security can be measured. It helps investors evaluate the effectiveness of their investment strategies.
Example: An investment manager might compare the performance of their actively managed fund to the S&P 500 to determine if their strategy is outperforming or underperforming the market.