What is the purpose of stock market indices? Here's how an investor can actually use an index (2024)

What is the purpose of stock market indices? If I look at news and social media, the purpose is clearly to generate a number representing how the markets are doing today or how they did yesterday. Added to this is the widespread ‘analysis’ that tries to find clues as to why the markets rose or fell. If this was all that the indices were good for, they would actually be good for nothing.

What can you, the investor, actually use an index for? It’s important to recognise that stock market indices do more than just provide a daily numerical snapshot of market performance. Every stock investor knows that market indices are like a report card for the overall market. They show how the market is doing, but not how each individual stock is doing. If you are only looking at the index, you might miss out on some good investment opportunities. For example, the index might be going up, but some stocks might be going down. You might not notice this if you’re only looking at the index. What else can we use the index for?

One great thing about indices, which most of us ignore, is that they serve as a bridge connecting the present with the past. They are historical archives, capturing the ebb and flow of the economy, business and market over time. In comparing the current positions of these indices to their historical levels, as well as the current patterns to the historical ones, we have a powerful tool for understanding not just where the market stands today, but how it got here and what might happen.

This historical perspective is crucial for several reasons. One, it helps demystify the often volatile nature of the markets, offering reassurance through the understanding that markets move in cycles. Considering how indices have rebounded from the past downturns can provide a sense of resilience and a longer term outlook, encouraging investors to look beyond short-term market fluctuations. When my research team is panicking about a dive in the markets, I give them first-hand accounts of what I saw and felt in 2007 or 2001 or 1993, and they are reassured. Instead of the hyperventilation about the crash on social media, this gives it a ‘been there, done that’ air to the entire event, which is reassuring.

Two, this historical lens helps us identify patterns that could inform future market movements. While history does not repeat itself perfectly, it often rhymes, meaning that understanding the past market responses to certain events can help us anticipate potential outcomes in similar future scenarios. This can be particularly valuable in times of uncertainty, where historical context can offer clues to how the markets might evolve.

Finally, this historical analysis fosters a more disciplined approach to investing. The investors who appreciate the cyclical nature of markets and the impact of long-term trends are more likely to adopt a strategic, long-term view rather than react impulsively to shortterm market movements. By looking at history, we can learn from others’ experiences, instead of always having to wait for our own.

Apart from the historical perspective, the biggest utility of indices is to serve as a benchmark. This is a term that mutual fund investors may be familiar with, but it’s just as useful when used personally by an investor. It’s easy to feel good about your investing prowess when the markets are doing well, but the real measure of investments is doing better than the markets, something that only the indices can tell you. This works both for individual stocks as well as the entire portfolio.

Whether you’re trying to decide to hold or sell an asset, rebalance your portfolio, or figure out if your investment strategy is working, benchmarks give you a frame of reference. Comparing your investments to benchmarks is like having an external examiner for your investment decisions—it’s much harder to fool it than oneself.

(The Author is CEO, VALUE RESEARCH)

...moreless

...moreless