Not just the day's numbers

What is the purpose of stock market indexes? If I look at the news and social media, the purpose is clearly to generate a number representing how the markets are doing today or how they did yesterday. Added to that is the widespread 'analysis' that tries to find clues as to why the markets rose or fell. If this is all that the indexes were good for, then they would be good for nothing.

What can you, the investor, actually use an index for? It's important to recognise that stock market indexes do more than just provide a daily numerical snapshot of market performance. Every stock investor knows that stock market indexes are like a report card for the overall market. They show how the market is doing but not about how each stock is doing. If you only look at the index, you might miss some good investment opportunities. For example, the index might be going up, but some stocks might be going down. You might not notice that if you're only looking at the index. This much is fine, but what else can we use the index for?

One great thing about indexes, which most of us ignore, is that they serve as a bridge connecting the present with the past. They are historical archives, capturing the ebbs and flows of the economy, business, and market over time. By comparing the current positions of these indexes to their historical levels and the current patterns to historical ones, we have a powerful tool for understanding not just where the market stands today but how it got here and what might happen.

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This historical perspective is crucial for several reasons. One, it helps demystify the often volatile nature of the markets, offering reassurance through the understanding that markets move in cycles. Seeing how indexes have rebounded from past downturns can provide a sense of resilience and a longer-term outlook, encouraging investors to look beyond short-term market fluctuations. When my research team panicked about some dive in the markets, I told them first-hand accounts of what I saw and felt in 2007, 2001, or 1993, and they were reassured. Instead of the hyperventilation about the crash on social media, this gives it a 'been there, done that' air to the whole thing that is reassuring.

In a related way, this historical lens helps us identify patterns that could inform future market movements. While history does not repeat itself perfectly, it often rhymes, meaning that understanding past market responses to certain events can help us anticipate potential outcomes in similar future scenarios. This can be particularly valuable in times of uncertainty, where historical context can explain how markets might evolve.

Finally, this historical analysis fosters a more disciplined approach to investing. Those investors who appreciate the cyclical nature of markets and the impact of long-term trends are more likely to adopt a strategic, long-term view rather than react impulsively to short-term market movements. By looking at history, we can, in a way, learn from others' experiences instead of always having to wait for our own.

Apart from a historical perspective, the biggest utility of indexes is to serve as a benchmark. Mutual fund investors may be familiar with this term, but it's just as useful when used personally by an investor. It's easy to feel good about your investing prowess when the markets are doing well, but the real measure of investments is doing better than the markets, something that only the indexes can tell you. This works both for individual stocks and our entire portfolio.

Whether you're trying to decide whether to hold or sell an asset, rebalance your portfolio, or determine if your investment strategy is working, benchmarks give you a frame of reference. Comparing your investments to benchmarks is like having an external examiner of your investment decisions - much harder to fool than oneself.

Also read: Panic and sudden meltdowns

This article was first published on February 27, 2024