Purpose and Limitations of Stock Market Index

What does the Stock Market Index mean? Stock Index futures offer the investor a medium for expressing an opinion on the general course of the market. The general movement of the stock market is usually measured by averages or indices consisting of groups of securities that are supposed to represent the entire stock market or its particular segments. Thus, Security Market Indices or Security Market Indicators provide a summary measure of the behavior of security prices and the stock market. So, what is the topic we are going to discuss: Purpose and Limitations of Stock Market Index!

Explained Stock Market Index Concept with their Purpose and Limitations!

The principal stock market indices used in India are the Bombay Stock Exchange Sensitive Index (BSE Sensex) and the S&P CNX Nifty known as the NSE Nifty (National Stock Exchange Fifty). In addition, these contracts can be used by portfolio managers in a variety of ways to alter the risk-return distribution of their stock portfolios. For instance, much of a sudden upward surge in the market could be missed by the institutional investor due to the time it takes to get money into the stock market.

Stock Index Futures:

By purchasing stock- index contracts, the institutional investors can enter the market immediately and then gradually unwind the long futures position as they are able to get more funds invested the stock. Conversely, after a run-up in the value of the stock portfolio (assuming it is well diversified and correlates well with one of the major indexes) a portfolio manager might desire to lock in the profits much after being required to report this quarterly return on the portfolio.

By selling an appropriate number of stock index futures contracts, the institutional investors could offset any losses on the stock portfolio with corresponding gains on future position. As a speculation tool, stock index futures represent an inexpensive and highly liquid short-run alternative to speculating on the stock market.

Instead of purchasing the stock that makes up an index or proxy portfolio, a bullish (bearish) speculation can take a long (short) position in an index futures contract, then purchase treasury securities to satisfy the major requirements. A long or short speculative futures position is referred to as a purely speculative position or a naked (outright) position.

The Purpose of an Index in the Stock Market:

The security market indices are indicators of different things and are useful for different purposes.

The following are the important uses of a stock market index:

• Security market indices are the basic tools to help and analyze the movements of prices of various stocks listed on stock exchanges and are useful indicators of a country’s economic health.
• Indices can be calculated industry-wise to know their tread pattern and also for comparative purposes across the industries and with the market indices.
• The growth in the secondary market can be measured through the movement of indices.
• The stock market index can be used to compare a given share price behavior with past movements.
• Generally, stock market indices are designed to serve as indicators of broad movements in the securities market and as sensitive barometers of the changes in trading patterns in the stock market.
• The investors can make their investment decisions accordingly by estimating the realized rate of return on the stock market index between two dates.
• Funds can be allocated more rationally between stocks with knowledge of the relationship of prices of individual stocks with the movements in the market.
• The return on the stock market index, which is known as the market return, is helpful in evaluating the portfolio risk-return analysis. According to modern portfolio theory’s capital asset pricing model, the return on a stock depends on whether the stock’s price follows prices in the market as a whole; the more closely the stock follows the market, the greater will be its expected return.

Purpose and Limitations of Stock Market Index, Image credit from #Pixabay.

Limitations of Stock Market Index (Indices):

Though stock market indices are the basic tools to help and analyze the movements of the price of the stock markets and are a useful indicator of a country’s economic health, they have their own limitations also.

The following points deal with those limitations:

• Whenever a company issues rights in the form of convertible debentures (to be converted at a later stage) or other instruments (warrants) entitling the holder to acquire one equity share of the company at a specified price at a notified future date, the equity capital increases only on conversion of debentures or the exercise of warrants/Secured Premium Notes (SPNs), option for equity shares but the market adjusts the ex-rights price of the share immediately (on the day the share starts trading ex-rights) on the basis of the anticipated increase in equity capital and likely reduced earnings per share, etc.
• Hence, some modification is needed to adjust the equity capital suitably in advance. But the exact procedure by which this can be done is very difficult to state since the internal market mechanism which adjusts the ex-rights share price is almost impossible to know precisely.
• Again, this is a common limitation of all the indices and so far, the increased equity capital is considered only after the debentures are converted into shares and are acquired for warrants/SPNs and the new shares are listed for trading on the stock exchange.
• The coverage (in terms of number of scrips, number of stock exchanges used and the respective weights assigned) is different for all the indices and hence, each index may give only a partial picture of the movement of prices or the state of the market presented may be misleading.
• The financial institutions sometimes convert the loans extended by them to companies into equity shares at a specified date. This causes sudden and significant changes in the market capitalization and hence the weights assigned to those scrips change violently.
• The various stock market indicators around the world have been in use for many years and it has satisfied the needs of millions of investors and stockbrokers. But the stock markets, by their very nature, are very dynamic and hence, the indices should be revised or adjusted periodically to reflect the changed conditions so that they continue to be relevant.
• Whenever prices of scripts listed on more than one stock exchange are used, most liquid prices (on anyone stock exchange) should be used (rather than the present practice of using the arithmetic average of prices on all the exchanges, as the same script may not enjoy the identical degree of liquidity on all exchanges).

The limitations indicated may not be eliminated totally, but appropriate adjustments are certainly called for. The classification of industries into various groups for calculation of various industry indices is presently rather vague and presents problems in the case of diversified companies. Also learned, What does Welfare Economics mean? Measuring and Value decisions!

This should be made uniform or the classification should be made in such a way that it reflects the major operations carried on by each company. Overall, one can say that the various stock market indicators devised have more or less served their purpose, despite their limitations but these can be made more effective and dynamic by introducing appropriate modifications 0£ the existing ones to serve the investing public better.