On today’s exchange, indices are almost almighty: they are used to instantly assess the market situation and predict the results of trading in the future, they evaluate the managers’ skills and invest in them.
Why do we need indices?
On Friday, January 12, 2018, the price of Alrosa shares on the Moscow Exchange fell by 0.6%, Sberbank shares went down by 0.2%. On the same day, shares of Inter RAO UES increased by 0.9%, NLMK – by 2.1%, and LUKOIL securities soared by almost 6%. Was it a good day for the Russian stock exchange or not? Even if you look at a table of 50 main stocks, where the decline is highlighted in red and the growth in green, it is difficult to confidently say something. Well, the red color prevails. Although one “green” LUKOIL easily outweighs thirty “red” Sberbanks. Or?
To be able to answer this question, Charles Dow, a journalist, and Edward Jones, a statistician, came up with the use of indices back in the century before last.
For example, the MOEX Russia Index, a set of about 50 shares with the largest volumes of transactions, shows that on January 12, a rather sluggish New Year rally continued and the market grew by 0.7%. An investor could understand that the market, has been growing, although slowly but steadily, since the first post-New Year trading on January 3, only by looking at the dynamics of the index.
What are the indices made of?
The first index of the very same Dow and Jones was arithmetic-mean. The prices of 12 shares included in it were added up and divided by 12, and then divided by the value on the first day of calculation – this is how the index value turned out. The MOEX Russia Index is weighted by capitalization: the total value of shares included in the index is divided by their total value on the first day of calculation and is multiplied by 100. Changes in the quotes of large companies with this approach have a stronger effect on the index dynamics. So now most indices are calculated. There are about 2000 indices in the world. Besides those that track the behavior of stocks on a certain trading platform (like the MOEX Russia Index), there are also global indices that show the movement of quotes of several exchanges that are part of the macroeconomic region (such as Europe, Asia or Latin America), industry indices, from extractive industry indices to company indices in the robotics or 3D printing sector.
The most important international indices
- DJIA (Dow Jones Industrial Average), an index of the New York Stock Exchange (USA), includes securities of major industrial companies;
- NASDAQ Composite, a stock index listed on the NASDAQ stock market; calculated according to quotes of companies of the “new” economy – Internet holdings, manufacturers of electronics and software;
- FTSE 100 (Financial Times Stock Exchange 100 Index), a share index listed on the London Stock Exchange (UK);
- S&P 500 index measures the stock performance of 500 large companies listed on stock exchanges in the US;
- Nikkei 225, Tokyo Stock Exchange Index (Japan),
- SSE Composite Index, Shanghai Stock Exchange Index (China).
How to use them?
Observing the index as a whole will not help you find an investment idea, but it may provide direction for your search or warn against mistakes. If the stock has fallen in price or increased noticeably faster than the index, something unusual is happening to it. On April 6, the United States imposed additional sanctions against Russian officials and entrepreneurs. This dramatically affected Rusal’s depositary receipts, which doubled in price in one day on the Hong Kong stock exchange. The company’s stock performance contrasts with the HSI Hong Kong Stock Exchange.
An analysis of the index dynamics can provide additional information to determine the optimal entry point into the market, if an idea has already been found. After all, securities are affected not only by news about the state of affairs of a particular company, but also by the general situation in the economy. When U.S. President Donald Trump announced in mid-March 2018 that he was going to impose duties on imports from China, the DJIA immediately declined. Investors were frightened of a trade war between two large world economies, which would inevitably lead to a drop in company profits on both sides of the ocean. After several days of decline, good macroeconomic statistics appeared, and analysts predict a further increase in the index. Perhaps now is the time to buy the desired stocks.
The dynamics of American and Asian indices is a guideline for Russian traders. DJIA, S&P 500 and NASDAQ are falling and traders on the Moscow Exchange will most likely sell securities, unless there is good news that encourage purchases.
Analyzing the results of investing for any period (e.g., a year or a quarter), it makes sense to compare them with the stock index dynamics. If a portfolio rises in price slower than the index (or cheaper faster), it may be worth revising its composition.
Beating the market is the dream of any investor, but usually it is not always possible to do this. As a rule, the market over long periods of time is more successful than even the most talented player. That’s where a very simple investment strategy comes from. If the market cannot be defeated, why not copy it?
How to train the market?
There are two ways to invest in an index:
- Buy stocks included in the index. For example, at the beginning of April 2018, the MOEX Russia Index included 46 securities. But it is not enough just to buy one share because its weight in the index varies depending on the capitalization of issuers.
- Buy securities of the so-called ETF (Exchange Traded Fund)—investment funds whose portfolio copies the composition of the corresponding exchange index. So far, the securities of 12 funds are traded on the Moscow Exchange: the RTS index, Russian corporate Eurobonds, gold, shares included in the MSCI international index, and short-term US government bonds.
Investing in the index, an investor solves two important tasks at once. Firstly, they form a portfolio, which significantly reduces the risks of a fall in the price of a single stock. Secondly, they save time: there is no need to follow the news and schedules, analyze reports and calculate fundamental indicators, in a word, look for investment ideas. All that is required is to compose a portfolio and forget the password from the trading terminal. Indeed, index investment is a super long-term strategy. Indices may fall on the horizon of a month or even several years, but they always grow in the end.