An index is a group of stocks representing a particular segment of the market or in some cases, the entire market. The market index consists of individual securities, usually called constituent securities, that represent a given security market, market segment, or asset class; mostly constructed as a portfolio of marketable securities.
Each index may have two versions depending upon how the returns are calculated. These two versions are:
a. Price Return Index. It is the normal index that we consider on the daily basis. It reflects only the prices of the constituent securities.
b. Total Return Index. It is the index that reflects the changes in prices, plus, it also assumes the reinvestment of all the incomes since inception.
1.1. Uses of Market Index
Security market indices indicate different aspects and are useful for different purposes. Following are the important uses of indices:
a. Security market indices are the basic tools to help and analyze the movement of prices of various stocks listed in the stock exchanges and are a useful indicator of a country’s economic health.
b. The return on the index, which is known as market return, is helpful in evaluating the portfolio risk-return analysis. According to the CAPM (i.e. capital asset pricing model), a stock’s expected return depends on its risk exposure, measured by the beta times the market risk premium, which is the expected return on the stock market as a whole.
c. Indices can be calculated industry-wise to know their trend patterns and also for comparative purposes across the industries and with the market indices.
d. Generally, market indices are designed to serve as indicators of broad movements in security markets and as sensitive barometers of changes in trading patterns in the stock markets.
e. The growth of the secondary market can be measured through the movement of indices.
f. Historical share price movements can help technical analysts to predict the movement of future share prices.
g. Investors can make their investment decisions accordingly by estimating the realized rate of return on the index between the two dates.
h. Funds can be allocated more rationally between stocks with the knowledge of the relationship of prices of individual stocks with the movements in the market.
i. The return on indices helps in the evaluation of the performance of the investment managers.