Explaining stock market indices

Last month, I received an e-mail from someone who wanted to understand indices. “I do not understand this index thing,” she wrote.

“Even the ones you are quoting about the Uganda Securities Exchange. Could you help me get to know how to interpret these figures, including the Hang Seng, the Dow Jones, and the Nikkei etc.?

An index is a tool used to measure the price changes of stocks representing part of the overall stock market. Under normal circumstances, a change in the price of index represents a change in the prices of companies included in the index.

Mr Charles Dow created the first index in 1896, consisting of 12 of the largest companies. But the number has long since changed to 30 of the largest U.S. companies; and, it is popularly known as the Dow Jones Industrial Average (DJIA).

The method used to compute the DJIA, commonly referred to as the Dow, is known as price-based weighting. Under this system, the weight of each share is the share’s price relative to the total of all the stock prices. This system has one main drawback. During stock splits, the weight of a company changes even if the fundamentals remain unchanged.

This explains why many indices use market capitalisation, that is, number of shares multiplied by the share price. If a company’s market capitalisation is Shs 1,000,000 and the value of all stocks in the index is Shs100, 000,000, then the company would be worth one percent of the index. There are many indices and some are national indicators.

The most common ones include the Nikkei 225, a stock market index for the Tokyo Stock Exchange (TSE). The Hang Seng Index is the stock market index in Hong Kong. The FTSE 100 Index is a share index of the 100 most highly capitalised companies listed on the London Stock Exchange.

But perhaps the most frequently quoted one is the Dow; and, you might have heard statements like “the Dow finished lower 45 points to close at 875. What does that mean, you probably wondered.

The number you hear while watching CNN or you read while checking out the business pages, is the weighted average of stock prices. This implies that the Dow is as good as a price in itself. Therefore, when you hear that the Dow Jones went down 45 points it means that shares that day would have cost you US$45 less to buy shares the day before at the same time.

Although the concept of indices sounds complicated, anybody can create an index. In the U.S., there are at least seven other major indices: the Standard and Poor’s 500 Index, NASDAQ Composite Index, Standard & Poor’s 500 Index, Wilshire 5000 total market index, and Rusell 2000 index. The distinguishing yardstick here is the reputation and integrity of the establishing party.

The Dow Jones Industrial Average, for instance, is owned by the publishers of The Wall Street Journal (the biggest daily business newspaper in North America), Dow Jones & Company.

In Uganda, the only index is the All Share Index (ALSI) created by the Uganda Securities Exchange. Other African countries have indices created or owned by their respective stock exchanges.

You have to interpret these indices correctly in order to make the right decisions.