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What is a market index and how might it affect your investments?

June 8, 2018

June 8, 2018

Investors who pay attention to the finance segment of the daily news may be gazing in awe at the performance of the US share market. Even taking into account the fall in early February, the Dow Jones Industrial Average has astounded veteran commentators worldwide with its monumental growth over the last 12 months. Meanwhile, the Australian All Ordinaries Index has yet to return to the height it enjoyed before the Global Financial Crisis at 6779.1 points.

This begs two questions: what are these indices? And what do their movements tell us about our investments?

What’s an index?

A share market index is a simple way of tracking the relative changes in the total value of the shares that are included in that index. There are many different indices covering particular national markets, as well as sectors such as large companies, small companies, financials, resources, technology companies and many more.

Capital indices– the type featured on the news each day – simply track the total market value of the companies in the index. This means the largest companies tend to dominate an index’s movements. Indices commonly appearing in news reports include the Australian All Ordinaries Index, comprising Australia’s largest 500 companies; the ASX 200 (Australia’s 200 largest companies); the US Dow Jones Industrial Index that tracks just 30 large industrial companies; and the US S&P 500 consisting America’s 500 largest companies. The NASDAQ is focused on technology stocks and can perform quite differently to the other US indices.

Capital indices ignore the contribution of dividends to the overall performance of the shares that they track. Accumulation indices are calculated on the basis that the dividends paid by each company are re-invested back into that company. They therefore measure compounding returns, and over time this makes a huge difference to the measured performance of the basket of shares. For example, the Australian ASX 200 accumulation index is well ahead of its pre-GFC peak.

This also explains one difference between the perceived performance of the Australian share market relative to the US market. American-based companies pay very low dividends compared to Australian companies. Retained earnings add to a company’s value, so US indices behave a bit more like accumulation indices than their Australian counterparts.

What do the index movements mean for your investments?

What the movement of a particular index tells you about the performance of your share portfolio depends on how closely the two match. If you are invested in an index fund that tracks the ASX 200, then naturally the changes in the value of the index will closely match the performance of your holding in that fund.

However, the Australian share market is dominated by a small number of very large companies. If the big banks are having a bad day the whole index is likely to fall, even if resources have had a good day. If your focus is on the miners, this change in the index may not tell you much about how your shares are performing.

Of course, if you’re following the golden rule of investment – diversification - your precious savings and superannuation will be invested in both Australian and international share markets as well as cash, fixed interest and property. Any given index can then only affect the performance of a part of your portfolio. Nonetheless, if you’re like most people, you’ll want to see the share market arrows on the TV pointing up and not down each day!

Australia vs the world

But why is Australia lagging other markets, particularly the US? One reason is the ‘Trump factor’, and his promise of a very large cut to the company tax rate. This will allow American companies to invest more of their earnings into growing their businesses and increasing their value. Also, Australia has a relatively small technology sector. The US has Google, Apple, Microsoft, Amazon – huge companies that didn’t exist a few decades ago. The massive investment that drove Australia’s mining boom is now past, and after growing strongly from their GFC lows, the banks have taken a bit of a breather.

Coping with market ups and downs

Another golden rule of investment is that past performance is no indicator of future performance. Indices go up, and as we’ve just experienced, they go down, usually suddenly. For advice on how to keep your cool during market gyrations talk to your financial adviser.

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The information on this site is of a general nature. It does not take your specific needs or circumstances into consideration, so you should consider your own financial position, objectives and requirements and seek personalised advice before making any financial decisions.