The Perils of the Immediacy Trap and Why we can and cannot do without it
February 12, 2025
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Stock market indices are ubiquitous. People come across these indices almost every day. However, many are not aware about their existence.
For instance everyone knows about NYSE, NASDAQ, FTSE, NIFTY etc. However, few are aware that they are referring to stock market indices when they talk about the markets going up or down. The New Stock Exchange is just an exchange. It does not rise or fall in value.
The indices calculated based on the data aggregated by New York Stock Exchange are what everyone seems to be referring to all the time.
In this article, we will provide a basic introduction of market indices. This will equip the reader to understand what these indices are and why they are important.
Market indices are merely statistical indicators. In financial markets, they are designed to let the people compare the performance of a portfolio of securities. This portfolio could represent an entire market or a particular segment of the market like banking, oil and gas etc.
The index can be easily created because the Pareto principle applies to financial markets. This means that only 20% of the companies that are listed account for more than 80% of the value on the stock exchange.
Hence, these indices only track the movements of a handful of companies in the market. Since these companies broadly represent the market the performance of the entire market can be gauged from their performance.
Index values only make sense when compared to a base value. The base value could be a previous day’s value or it could be the value from many years ago. Usually the base value of an index is 100. The base value, along with the base year, need to be known in order to determine the compounded annual growth rate at which the securities have been growing.
Indices can be used for many purposes. Some of them have been mentioned below.
To know whether a stock outperformed the others, it is essential that the growth of the stock be known and the growth in the relative index be known.
A stock cannot said to have outperformed even if it grew by 20%. If the index grew by 25% during the same period, a 20% growth would instead be considered a lackluster performance.
A stock is said to be more or less risky in comparison to other stocks in the market. Data is collected which compares the risk of the stock vis-a-vis the indices. This data is then converted into a statistical measure called “beta” which is the universal measure of riskiness.
Market indices must have certain characteristics. The important ones have been listed below:
Indices can be created based on multiple methodologies. In the next article, we will study some of the methodologies that are used to construct these indices and how they affect the outcomes of those indices.
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