ECONOMIC SIGNIFICANCE OF INDEX MOVEMENTS
How do we interpret index movements? What do these movements mean? They reflect the changing expectations of the stock market about future dividends of the corporate sector. The inde.’S goes up if the stock market thinks that the prospective dividends in the future will be better than previously thought. When the prospects of dividends in the future becomes pessimistic, the index drops. The ideal index gives us instant readings about how the stock market perceives the future of corporate sector.
Every Stock price moves for two possible reasons:
1.News about the company (eg., a product launch, or the closure of a factory).
- News about the country (eg. Budget announcements)
The job of an index is to purely capture the second part, the movements of the stock market as a whole (i.e.. news about the country). This is achieved by averaging. Each stock contains a mixture of two elements – stock news and index news. When we take an average of returns on many stocks, the individual stock news tends to cancel out and the only thing left is news that is common to all stocks. The news that is common to all stocks is news about the economy. That is what a good index captures. The correct method of averaging is that of taking a weighted average, giving each stock a weight proportional to its market capitalization.
EXAMPLE: Suppose an index contains two stocks. A and B. A has a market capitalization of Rs. 1000/- crore and B has a market Capitalization of Rs.3000 crore. Then we attach a weight of 1/4 to movements in A and 3/4 to movements in B.
INDEX CONSTRUCTION ISSUES
A.good index is a trade-off between diversification and liquidity. A well diversified index is more representative of the market/economy. However there are diminishing returns to diversification. Going from 10 stocks to 20 stocks gives a sharp reduction in risk. Going from 50 stocks to 100 stocks gives very little reduction in risk. Going beyond 100 stocks gives almost zero reduction in risk. Hence , there is little to gain by diversifying beyond a point. The most serious problem lies in the stocks that we take into an index when it is broadened. If the stock is illiquid, the observed prices yield contaminated information and actually worsen an index.
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