Do you know what the Paasche Formula is? You don’t? Well then, we’ll just have to skip the Advanced Statistics course. Please proceed to Elementary Statistics.
Let’s say we have a selection of public companies, each with a number of stocks on the market. If we multiply this number by the stock’s current share price, we get each company’s market capitalisation. The combined market capitalisation of all the companies makes up the total market value.
This market value is an enormous, unwieldy multi-digit number. It’s certainly not convenient or manageable. And we all want convenience, don’t we? So, let’s divide this market value by any number that could make the index value equal to 100. What we get is called the Index Divisor. Sounds professional and convincing, doesn’t it?
After a while, the shares will rise in value. How do we know? Well, that’s what normally happens to most healthy stocks over time. So, the market capitalisation of the companies will also rise. As a result, the total market value will now be greater than before. Now, remember that Index Divisor? Let’s divide the new market value by that Index Divisor. We’ll get something in the range of 100, but greater – say, for instance, 102.
So, instead of comparing the astronomical figures of the total market value now and then, we can instead just compare 100 to 102 and see the same dynamic. Convenient, isn’t it? This is what most stock market indices mean when they say “Index such and such rose from 100 to 102 over this period”.
Congratulations, you’ve just completed the Elementary Statistics course.
Understanding the “why” is important here. As investors, we need those indices. There are thousands of public companies, with millions of shares-in-issue, and billions of currency units of market value – and they are all different. Before investing in one or another, we want to get a general impression of the market. For example, is it in bad shape or is it euphoric? Is it plummeting like when the virus first hit, or are those share prices shooting up again like mushrooms? The stronger the market macro-factors are, the greater the chance they will override the trend of a particular company. That’s why you’re going to want to know what the market weather is like before considering this or that stock to invest in. That’s what market indices are for: to give you a sense of the prevailing conditions.
Could be helpful to know: That was just a general idea of market indices. Diving deeper into the subject, we will notice good old diversification. Investors benefit from index investing as indices act to naturally diversify a portfolio. Market indices consist of a broad basket of stocks instead of a few hand-picked assets.
In fact, you may find it much easier to assess market indices than individual stocks – and that makes sense. Each company has its own individual situation and peculiarities to take account of (not that you have to, though; you could just invest because you like that stock. You choose how “academic” you want to be, and Orca will fix you up with whatever tools you need). With market indices, you can get a general overview, a summary that the experts in the field have already worked out for you. So, if you’re thinking, “Wouldn’t it be nice to be able to just invest in those indices rather than having to choose particular stocks?”, you can. Others have had that same thought – and made it possible for you. So you can enjoy investing in stock market indices – like S&P for the US stock market and FTSE for the London Stock Exchange – as if these were regular stocks.
How to find indices
With Orca, you can buy ETFs related to a specific index. And, as usual, it’s easy. Go to Search, enter “S&P” or “FTSE”, and you’ll get the corresponding market indices to choose from. Then, you know what to do. Enjoy investing!
If you’re curious, the Paasche Formula is related to the FTSE – you can discover more if you dig into the FTSE calculation method on its official website. The author of the formula is Hermann Paasche, a German statistician and economist who lived a century ago. He’d probably be astonished by the complexity of modern economics, and he’d surely find it difficult to navigate the modern stock market and invest properly… unless he was with Orca.