Stock market indices: understanding the barometers of the stock market

What is a stock market index?

A stock market index is a virtual basket containing a selection of shares. Its purpose is to measure the overall performance of a section of the stock market. Think of it as a thermometer: it tells you whether the economic temperature is rising or falling.

Each index represents a different group of companies. The CAC 40 (France) comprises the 40 largest French companies. The DAX (Germany) also comprises 40 companies. The S&P 500 (United States) comprises 500. The higher the index rises, the more the companies in it increase in value, on average.

Indices serve as benchmarks. They enable investors to quickly gauge whether the market is performing well or poorly, without needing to analyse each share individually.

How does a stock market index work?

An index is calculated using a weighted average (meaning that some shares carry more weight than others). Let’s take a simple example involving three fictitious companies.

Let’s imagine a small index comprising: Company A (price100 €), Company B (price50 €), Company C (price200 €). If each share carries equal weight, the index’s initial value is (100 + 50 + 200) ÷ 3 = 116.67 points. A few weeks later, the prices become: A (110 €), B (55 €), C (210 €). The new index stands at (110 + 55 + 210) ÷ 3 = 125 points. The index has risen by 8.33 points, which means that the companies in the basket have, on average, increased in value.

In fact, indices are often weighted by market capitalisation (that is, the size of the company). The largest companies have a greater influence on the index’s movement.

The main global indices

Each country or region has its own indices. In France, the CAC 40 is the most widely followed. In Germany, it is the DAX. In the United States, the S&P 500 and the Nasdaq are very popular. In Asia, the Nikkei (Japan) and the Hang Seng (Hong Kong) are key benchmarks.

These indices reflect the economic health of their respective regions. If the CAC 40 rises sharply, this suggests that major French companies are doing well. If the S&P 500 falls, it is a sign that US investors are concerned.

There are also sector indices (for example, an index comprising only banks) or global indices that include companies from several countries.

The limitations and risks you need to be aware of

An index represents only a part of the market. The CAC 40 comprises just 40 companies out of the thousands listed on the stock exchange. A rising index does not mean that ALL shares are rising: some small companies may fall in value whilst the large ones rise.

An index can also be influenced by just a few companies. If the five largest companies in the CAC 40 fall sharply, the index will fall even if the other 35 rise slightly.

Finally, past performance is no guarantee of future results. An index that has risen for five years may fall over the next five years. You should never invest simply because an index has performed well recently.