Source Material

 Reilly, F. K. & Brown, K.C. (2003). Investment Analysis, Portfolio

Management. 7th Ed. South Western Publishing



Market Indices

 If an investor owns more than a few stocks or bonds, it is cumbersome to

follow each stock or bond individually to determine the composite

performance of the portfolio.

 Also, there is an intuitive notion that most individual stocks or bonds move

with the aggregate market.

 Therefore, if the ov erall market rose, an individual’s portfolio probably also increased in v alue.

 Indexes are useful in assessing investment results.

 They provide a benchmark against which performance can be compared.

 They are also useful in financial research, through which an investigator seeks to discover the relationship between certain economic v ariables and market results.



Uses of Security Market Indexes

A benchmark to evaluate the performance of professional money managers

 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.



Uses of Security Market Indexes

To Create and Monitor an Index Funds:

 Indicator series are also used to develop an index portfolio.

 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 the 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).



Uses of Security Market Indexes

To measure market rates of return in economic


Securities analysts, portfolio managers, and

others use security market indexes to examine

the factors that influence aggregate security

price movements

T hat is, the indexes are used to measure aggregate market movements.



Uses of Security Market Indexes

For predicting future market movements by technicians:

 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




Uses of Security Market Indexes

As a proxy for the market portfolio of risky assets when

calculating the systematic risk of an asset

 Works in portfolio and capital market theory have

implied that the relevant risk for any 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.



Differentiating factors in Constructing Market Indices

 Because the indicator series are intended to reflect the

overall movements of a group of securities, it is necessary to

consider which factors are important when constructing an

index that is intended to represent a total population.

 The following factors are important:

 The Sample

 Weighting Sample Members