ASX 200? S&P 500? What is an Index?

We all see the numbers at the end of the news before the weather, ‘the ASX was up 1.5% today whilst the Dow Jones was down 0.7%’ but what does it all mean. Stock market indices are a measurement of the value of a particular section in the stock market. The two most common methods to help determine the price of indices are by either the capitalisation-weighted (market-weighted) or price-weighted method. Capitalisation-weighted indices factor in the size of the company with the larger capitalised companies having more influence. Conversely a price-weighted index takes into account the market price of the share and places greater influence on individual share prices.

Some of the most common indices are:

ASX 200: is the index consisting of the capitalisation-weighted largest 200 companies listed on the Australian Stock Exchange. Some of the companies include the well known Big 4 banks, Woolworths, Telstra, Wesfarmers as well as mining companies Rio Tinto and BHP Billiton.

All Ordinaries: the oldest index in Australia, the All Ords consists of the largest 500 companies on the ASX using the capitalisation-weighted method. The index makes up 95% of the total value of all shares listed on the ASX.

S&P 500: the most well known index around the world, the Standard & Poors 500 is an index of the largest 500 companies by market capitalisation. The shares have to be listed on the NYSE or NASDAQ (two largest stock exchanges located in New York). The shares must also pass liquidity tests in order to qualify. It is often used as an indication of how the US economy is going.

Dow Jones: the Dow Jones Industrial Average is a price-weighted index containing 30 of the largest companies in the US. The index has kept its name for historical purposes but now consists of companies in various industries.

FTSE 100: the Financial Times Stock Exchange is an index of the largest 100 shares listed on the London Stock Exchange weighted by capitalisation. Companies included within the index include BP, HSBC, Shell and Vodafone.

Image: http://www.istockphoto.com/au/photos/stock-market

Book Bits: Little Book of Common Sense Investing

This book was written by legendary investor John C. Bogle in 2007 to show the public the benefits of passive investing. Bogle founded the Vanguard Company in 1974 and has now grown to over $4 trillion in assets under management, the largest managed fund provider in the world. Vanguard is credited with offering the first index fund to average investors and revolutionised the industry by offering minimal management fees. For an article on what an ‘index’ is click here.

Bogle’s philosophy is simple: people can’t successfully predict short-term market gyrations over a long period of time, even the professionals. When someone does beat the market they charge high performance fees to do so. When you sell there are also taxes that reduce the investors return. The solution is to not try and exceed the benchmark performance but to try and mirror it as closely as possible and when you buy don’t sell, just hold.

The book tells a version of a parable first developed by Warren Buffet and it explains the impact the financial systems have on active investing. Here is a short summary:

The expansive Gotrocks family owned 100% of the shares available in the US and each year they received the benefit of the earnings growth and dividends that these companies paid. The family grew wealthier each year at an even pace between themselves and they compounded their returns over a long period of time amassing great wealth. After a while a group of fast talking ‘Helpers’ arrived and persuaded the more intelligent members of the Gotrock family into earning a larger share than the other members. The Helpers told the intelligent members to sell certain shares to other family members and buy certain shares in return. The Helpers received a commission for their services. The Gotrocks found their investment returns growing at a slower rate; this was due to some of the return being consumed by the Helpers. To make matters worse previously the Gotrocks only ever paid tax on their dividends but started paying capital gains tax on the sale shares. The intelligent members realised that their stock picking idea didn’t work and needed to seek paid professional advice from the experts, more Helpers, to regain the advantage. Worse again the new managers of these investments felt compelled to earn their keep by trading at high levels further increasing the fees paid to the Helpers and the tax paid. The intelligent members were disheartened and decided to seek the help of more Helpers as investment consultants to help pick better managers and their slice of the pie further diminished. The family’s total 100% share of the pie dwindled down to 60% before they met and finally decided to go back to their roots of passively waiting for the productivity of the companies they own to provide the returns not trying to beat the market.

This vital lesson looks great on paper but takes discipline to achieve. People with no knowledge of individual companies are more suited to a passive style of index investing. The book is quite short and a recommended read for all.