Stock market indices
Investors generally talk about stock market indices, such as the Dow Jones Industrial Average (DJIA), and the Kuala Lumpur Stock Exchange Composite Index (KLCI). Questions such as “what happened to the stock market today?” or “what did the Index close at today?” often surface in every day discussions. But, what is the true significance of such indices to the investing process?

What do indices represent?
If an investor owns more than a few stocks, it would be difficult for him to monitor each stock individually to determine the overall performance of his stock portfolio at any one point in time. One way of keeping track of the portfolio performance is by tracking the performance of a widely published, and publicly available “market” portfolio that is composed of many different stocks – known as an Index. This portfolio is representative of the overall stock market and should provide the investor with a “feel” of how his own stocks are doing. It is intuitive that if the overall market is doing well, then the individual stocks held by the investor should also be doing well, and vice-versa.

Apart from this function, indices also have various other uses; some of which are:

• To compute the total return for the aggregate stock market over a period of time, which can be used as a benchmark to compare the portfolio performance of funds, managed by professional managers.
• Indices are often utilised for the development of an index portfolio – some investors are contented to receive rates of return equivalent to the market returns and this has led to the creation of index funds, which basically emulate the market index portfolio.
• Analysts and portfolio managers often use indices for the computation of systematic risk by using the capital asset pricing model (CAPM). In this case, the rate of return of the market is required and the rate of return on the market index is usually used as the proxy.
• For technical analysis – past changes in the index can be used to predict the future price movements of the overall stock market using technical indicators.