Indices are rough tools, not crystal balls

PF University Indices are general guides to the performance of stock markets, and they show you how well (or badly) overall markets are doing. So how can you use them to your benefit?

How are the stock markets doing? What's the Footsie? Where's the S&P? These are snapshot questions designed to measure how your investments are doing. And the answers are brief because they refer to indices. Indices are general guides to the performance of stock markets, and they show you how well (or badly) overall markets are doing. An index, therefore, is a statistical measure that represents the value of a batch of shares. The oldest one is the Dow Jones Industrial Average (DJIA), which was created by Mr Dow in 1896 with 10 stocks and, as one of the most important indices in the world, is used today as a benchmark for the US market; it now contains 30 stocks. The Standard and Poor's 500 (S&P 500) tracks the 500 largest publicly traded companies in the US. The S&P, however, is measured by market capitalisation and is a better indicator of the overall market than the DJIA, which is calculated by dividing 30 combined share prices by 30 to produce an "average".

The other major US index is the National Association of Securities Dealers Automated Quote, or Nasdaq for short. The Nasdaq is comprised of two indices: the Nasdaq Composite Index, which covers more than 5,000 companies traded on Nasdaq; and the Nasdaq 100 Index, which tracks the 100 largest companies on the exchange - usually technology giants such as Microsoft and Adobe. In the UK, the Financial Times Stock Exchange 100 (the FTSE 100) is the most famous market barometer. It tracks the Top 100 UK companies traded on the London Stock Exchange (LSE). These 100 stocks represent about 85 per cent of the value of all stocks traded on the LSE.

This means that if the largest companies hit a bad patch, as bank shares did in 2008, the effect on the index can be outsized. Since the FTSE only comprises 100 shares, the Financial Times Group also publishes the FTSE 250, the FTSE Small Cap and the FTSE All-Share, which covers around 700 companies. However, although the FTSE All-Share is a reliable indicator of the market's overall status, the Top 10 companies account for more than 40 per cent of the index's value.

Finally, all stock exchanges around the world have an index that you can follow: the Nikkei in Japan, the DAX in Germany; France's CAC-40, to name a few big ones. So, now that we have learnt about indices, how can we use them for our benefit? Since they give us an instant snapshot of what a market is doing, we can compare our investment performance with the index. For example, if the FTSE 100 is up 10 per cent and your portfolio of, say, 20 FTSE 100 shares is up 15 per cent at that time, it means you have invested your money wisely, which is what it's all about.

You can also invest directly into an index. The best ways are through so-called tracker funds, which invest only in shares that make up a particular index. Note that the index can be industry-specific. You can also buy an exchange-traded fund (ETF); they are similar to tracker funds except that they are traded like shares, meaning they give you diversification with the flexibility of individual stocks.

You can find out more about ETFs and tracker funds from your financial adviser, but remember that serious investors tend to look at broad-based indices and industry or sector indices. John McGaw is a financial adviser based in Dubai. Contact him at [e-mail]