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How Indices Mislead Small Stock Market Investors

17 July 2006 - Features - Editor

Stock market analysts love indices. There is more than one index for commodities, metals and for all significant industrial sectors. Market capitalization is itself the subject of an index, which is commonly taken as a barometer of economic health. Indices can help people with enormous funds decide on country priorities-in which territories should they expand portfolios. They can also be used to choose sectors within a stock market.

However, an index may have so many shortcomings that top stock market investors commonly use them much less than they claim! The average which an index represents may be distorted by massive spreads in performance by some of the heavyweight individual elements. Valuable investment opportunities can be lost as a result, and erroneous conclusions about upward trends are equally possible.

Most indices used in stock market decisions are based on samples rather than on aggregates. The selection of elements that go in to a basket can lose relevance over time, and historical trends can be meaningless as a result. This is especially the case with emerging segments and those which face dramatic obsolescence. Fears about the latter may be exaggerated, as vacuous claims may be as well. Factors that require political judgments about far away places are especially subject to the vagaries of sudden discontinuities.

Powerful financial institutions use informal networks to read between the graphics of every index that appear on their screens. The truth is rarely disclosed to small outsiders, for it is considered to be a trade secret. It is not uncommon for influential stock market investors to make statements quite at variance with private instructions they give their stock brokers!

Small investors should focus on the micro-environments of the companies in which they invest. Changes in the supply demand balance, new competition and management effectiveness matter more than vague movements in the macro environment. It is better to observe day-to-day moves of relevant companies with analytical eyes than to rely on the general and irresponsible remarks of third parties.

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indices, commodities, metals, capitalization, investors

 



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