Size Matters II

Yesterday we received a question from a keen reader, asking us to expand a little bit on the Indexes in general. Below is their question and our teams’ answer. Hope it helps and keep the questions coming.

Long-time reader, first time writer. 😉

Thanks for today’s email on the ASX.

A couple of questions remain though: what is the actual number? Is it a dollar value? Is it a ‘point’ value? And if it’s a dollar value, how is that value calculated? If, for example, the Dow Jones is at 21,813 vs the ASX200 which is 5,703, does that mean that the value of the stocks that make up the Dow Jones is four times greater than the ASX? Are US stocks worth more (in market cap dollars) than Aussie stocks?

What actually makes up the number and why are some indices so much higher than others??

5 Minute Finance’s Response
Great questions. Lets go back to the beginning. Before the ASX200 existed, Australian investors used to track the “All Ordinaries” Index.  The All Ordinaries, which is still around today, is made up of the 500 largest companies  in Australia. So it’s pretty similar to the ASX200 index, albeit it includes a lot more companies (300 more). When that index started in January 1980, it had an initial value of 500. Importantly, 500 doesn’t and didn’t actually mean anything. It’s just an arbitrary starting points value. That’s all. Cause every Index needs one. The change in the index value, which is the more important thing to pay attention to, is a representation of the change in the total value of the largest 500 companies. So if the total value (ie market capitalisation) of each of the 500 largest companies was to go up by 10%, then the value of the All Ordinaries Index would go up by 10%. Make sense?

On the 31st of March, 2000 the value of the All Ordinaries index was 3,133.3. This means that between 1980 and 2000, the market-capitalisation (ie value) of the largest 500 companies was up more than 6-fold (from 500 to 3,133.3). 31 March, 2000 also happened to be the date that the the ASX200 Index started. To make these indexes comparable over time, the starting value of the ASX200 was set as 3,133.3. See, arbitrary. The total value of the 200 largest companies is obviously not the same as the total value of the largest 500 companies, but the value of their indexes started off the same anyway. Again, it makes them more comparable. But, and again, what we care able is not the absolute level of the index, what we care about is the change in value of it. And more importantly the percentage change.

FYI the value of the All Ordinaries is currently 5,765. The value of the ASX200 is 5,700. So over the last 17 years (since March 2000), the ASX200 has slightly underperformed the All Ordinaries. Put another way, smaller companies (those between the 200th and 500th largest) have slightly outperformed larger companies. But only just.

Not all Indexes are created equal
So that’s the ASX200. The thing is, different indexes all have different starting points and starting values. For example, the Dow Jones which you reference, first started back in 1896! It’s a different kind of index, but it basically represents the 30 largest companies in the United States. There are a couple of things to note here… First, its starting value was 40.94 back in 1896. Very different to the 500 points which the All Ordinaries started with, or the 3,133.3 that the ASX200 begun at. Second, Index consistuents, ie the companies which make up the index, change over time. The largest companies in the US back in 1896 are very different to the largest companies in the US today. Companies which made up the original Dow Jones included United States Leather CompanyUnited States Rubber CompanyNorth American Company and American Sugar Company (really thoughtful names huh?), none of which exist today. On the other hand Apple, the largest company in the world didn’t exist back then.

So because different indexes start with different values, and because different indexes start at different times, the absolute value of any index is irrelevant and cannot be compared. Instead what is important is the change in value of the index and specifically the percentage change of it over time. For example, at the start of this year the ASX200 Index was at 5,699 points. Today it’s at 5,706. That’s a percentage change of 0.12%. Pretty meaningless. On the other hand, the Dow Jones was at 19,819 on 1 January, and has risen to 21,813 today. Thats a 10.06% jump! What does that all mean? It means that stocks in the US have outperformed stocks in Australia this year by a pretty significant margin. Interesting…

Succinctly on the questions..
What is the actual number? It is arbitrary and meaningless. It’s not the absolute number your care about, but rather the % change in the number over time.
Is it a dollar value? Is it a ‘point’ value? It is a points value. But just Who’s Line is It Anyway, the points don’t matter. Well not really anyway. We care about % change of the index.
If, for example, the Dow Jones is at 21,813 vs the ASX200 which is 5,703, does that mean that the value of the stocks that make up the Dow Jones is four times greater than the ASX? No. Not all indexes started at the same time, or with the same value. So their current level is not comparable to another index. What you care about however is the % change of one index vs another. That’s the important part. % change, I’ll say it one last time. % Change.

And that’s 5 minutes…. Hope it helped. 

Got a finance question, but short on time? Send us an email at daily@5minute.finance and we’ll help you out

 

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Categories: General Finance, Investing, Markets

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