What’s a stock index number and how to compute it

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SummaryMany of us deal with the stock markets on a daily basis — as investors, brokers, dealers or financial analysts.

Many of us deal with the stock markets on a daily basis — as investors, brokers, dealers or financial analysts. And, to gauge the performance of the market, we typically seek information on a stock index number. What is an index number? It is a summary measure of the performance of the stock market as a whole.

Changes in its value serve as a barometer of happenings that have a bearing on the performance of financial securities. Why do we need an index number?

As of July 2012, about 1,650 companies were listed on the National Stock Exchange (NSE). If someone were to give you information on the price changes or returns for these companies from one day till the next, in the form of 1,650 values, can a rational mind deduce meaningful conclusions about the performance of the market? Clearly, it would be impossible and we would seek a summary statistic.

There is more than one method for computing a stock index number. The common approaches are: the price-weighted technique, the value-weighted technique and the equally weighted method. Irrespective of the computational method, the first step in constructing a stock market index is to decide how many companies ought to be represented, and which ones in particular.

Although the number of companies represented by an index is usually constant, the composition of the indices will typically change over time as the global economy evolves. For instance, the Dow Jones Industrial Average (Dow), which is by far the best known stock index in the world, is based on the prices of 30 companies, and was computed for the first time in 1896. Over the years, as the industrial and information revolutions have unfolded, the structure of the world economy has changed.

Information technology companies now command a lot of attention, both in the West and in India. Quite obviously, 30 years ago, this would not have been the case. An index ought to be broad-based and represent a significant cross-section of the market that it is trying to mirror.

The Dow is based on 30 stocks and is price-weighted. A price-weighted index is computed by adding up the latest prices of all the component stocks and dividing the price aggregate by a number known as the ‘divisor’.

On the ‘base date’, which is the day on which the index is being computed for the first time, the divisor can be

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