If you take a look at the business section of a newspaper, you will always find several pages dedicated to the FTSE Bursa Malaysia Kuala Lumpur Composite Index (FBM KLCI). Generally, the index is used by investors to gauge the overall stock market performance in Malaysia. But did you know, not many people really understand what the stock market index is and how it is calculated? If you’ve never really understood the stock market index, this handy guide will tell you how. Upon reading this article, you will be able to:
• identify the characteristics of stock market index,
• identify how the stock market index is calculated, and
• recognise how the stock market index can affect your investment decision
• identify how the stock market index is calculated, and
• recognise how the stock market index can affect your investment decision
1) What is a stock market index?
A stock market index is a number calculated from the prices of a specific group of stocks for a defined market. The index will usually have the following characteristics:
A stock market index is a number calculated from the prices of a specific group of stocks for a defined market. The index will usually have the following characteristics:
• Investable - the stocks included in the index calculation are free-float weighted to accurately represent the stocks’ availability for investment. This means shareholdings by directors and founding families, government, cross holdings by related companies and holdings subject to lock-in clauses will be excluded from the calculation. This is especially important in the indices that follow the market capitalisation-weighted methodology;
• Tradable - ensure sufficient liquidity for the ease of trading for all the stocks included in the index; and
• Transparent - a clearly defined set of ground rules provides transparency and ease of understanding on the management of the index.
• Tradable - ensure sufficient liquidity for the ease of trading for all the stocks included in the index; and
• Transparent - a clearly defined set of ground rules provides transparency and ease of understanding on the management of the index.
When the index is a broad-based index representing the national economy and the entire stock market performance (such as the FBM KLCI, the US Dow Jones Industrial Average or the Japanese Nikkei 225), companies included in the index calculations are usually the ones which are primary market movers listed in the nation’s stock exchanges that have strong linkages to the country’s economic development. There are also specific indices that are narrower in scope, such as indices that represent specific sectors or industries.
[1] A method by which the market capitalisation of an index's underlying companies is calculated. Free-float methodology market capitalisation is calculated by taking the equity's price and multiplying it by the number of shares readily available in the market. Instead of using all of the shares outstanding like the full-market capitalisation method, the free-float method excludes locked-in shares such as those held by promoters and governments. (source: www.investopedia.com)
2) How is a stock market index calculated?
There are three main types of market indices, based on the weighting scheme being used in deriving the value of the stock indices, namely price-weighted, market capitalisation-weighted and market share-weighted indices:
There are three main types of market indices, based on the weighting scheme being used in deriving the value of the stock indices, namely price-weighted, market capitalisation-weighted and market share-weighted indices:
Index
|
Price Weighted Index
|
Market capitalisation-weighted
|
Equal-weighted Index
|
Description
|
Average price of companies included in the index
|
Total market value of the companies included in the index is taken into consideration
|
All stock returns are given the same weight
|
How it is calculated
|
(Add the market price of all stocks in the index)
÷
(number of stocks in the index)
|
(The sum of the current stock prices)
×
(number of shares outstanding of all stocks in the index)
|
Index is calculated with equal dollar investment in each stock in the index
|
Characteristics
|
Sensitive to large stock price movement regardless of the size of the company
|
A small shift in the price of a big company will heavily impact the value of the index
|
Tends to have higher stock turnover than market-capitalisation weighted index funds and, as a result, they usually have higher trading costs
|
Example(s)
|
Dow Jones Industrial Average and Japanese Nikkei 225
|
Bursa Malaysia
|
US Value Line Composite Average
|
3) What are indices used for?
A stock index is generally used as an economic indicator for investors to gauge the overall economic development and market performance. In addition, fund managers and investors who wish to manage their investment portfolio according to market performance will select appropriate stock indices as the benchmarks to their investment portfolios. Stock indices are also being used as the underlying instruments in some exchange traded funds (ETF), index mutual funds or equity derivatives, such as equity futures and swaps.
4) FTSE Bursa Malaysia KLCI
The FTSE Bursa Malaysia KLCI consists of the largest 30 companies listed on the Main Market of the Bursa Malaysia stock exchange, by full market capitalisation that meet the eligibility requirements of the FTSE Bursa Malaysia ground rules. The index is calculated based on a value weighted formula and adjusted by a free float factor, using the real time and closing prices sourced from Bursa Malaysia. The FTSE Bursa Malaysia KLCI values are calculated and disseminated on a real time basis every 15 seconds. The continuity of the KLCI index value also preserves the historical movements of the Malaysian stock market.
Conclusion
Conclusion
f you are a first time investor, a good starting point for learning about the stock market is stock market index calculation. Familiarity with stock market index calculation will help you analyse and follow the movement of the stock market in a fast manner from day to day, month to month or even year to year. A deeper understanding of stock market calculation will also help you anticipate possible movements in the stock market, without having to rely on speculation or guesswork. This will then allow you to make quick and effective stock market decisions including when to sell, buy or hold your stocks.
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