Security market indexes have at least five specific uses. A primary application is to use the index values to compute total returns and risk for an aggregate market or some component of a market over a specified time period and use the rates of return and risk measures computed as a benchmark to judge the performance of individual portfolios.
A basic assumption when evaluating portfolio performance is that any investor should be able to experience a risk-adjusted rate of return comparable to the market by randomly selecting a large number of stocks or bonds from the total market; hence, a superior portfolio manager should consistently do better than the market.
Therefore, an aggregate stock or bond market index can be used as a benchmark to judge the performance of professional money managers. Indicator series are also used to develop an index portfolio.
As we will discuss later, it is difficult for most money managers to consistently outperform specified market indexes on a risk adjusted basis over time. If this is true, an obvious alternative is to invest in a portfolio that will emulate this market portfolio.
This notion led to the creation of index funds, whose purpose is to track the performance of the specified market series (index) over time. The original index fund concept was related to common stocks.
Subsequently, development of comprehensive, well specified bond market indexes and similar inferior performance relative to the bond market by most bond portfolio managers have led to a similar phenomenon in the fixed-income area (bond index funds).
Securities analysts, portfolio managers, and others use security market indexes to examine the factors that influence aggregate security price movements (that is, the indexes are used to measure aggregate market movements).
Another group interested in an aggregate market series is “technicians,” who believe past price changes can be used to predict future price movements. For example, to project future stock price movements, technicians would plot and analyze price and volume changes for a stock market series like the Dow Jones Industrial Average.
Finally, work in portfolio and capital market theory has implied that the relevant risk for an individual risky asset is its systematic risk, which is the relationship between the rates of return for a risky asset and the rates of return for a market portfolio of risky assets.
Therefore, in this case, an aggregate market index is used as a proxy for the market portfolio of risky assets. In summary, security market indexes are used:
➤ As benchmarks to evaluate the performance of professional money managers
➤ To create and monitor an index fund
➤ To measure market rates of return in economic studies
➤ For predicting future market movements by technicians
➤ As a proxy for the market portfolio of risky assets when calculating the systematic risk of an asset.
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