Indices versus stocks and shares is a tricky question. You can trade both, but most people prefer to stick to one or the other. Let’s take a look at both and discuss the pros and cons.
What are Indices?
Indices are compilations of stocks and shares. The FTSE 100 is an index of the top 100 companies listed on the London Stock Exchange. There are many others, including the S&P 500 Index, the Hang Seng Index, the Dow Jones Industrial Average, the NASDAQ 100 Index, and so on.
An indices performance is measured in points. For example, if the FTSE 100 goes up by 56 points, the overall value of the companies listed in the index has risen in value. When the value of stocks and shares fall, the index loses points.
When you purchase shares in the FTSE 100, you are essentially buying shares in ALL the companies listed in that index. The value of an index is derived from the average value of each company or entity in the index. If you elect to purchase shares in a single company, the value of your investment goes up or down according to the performance of that company.
The Benefits of Trading Indices
Trading in indices is more cost-effective than trading in individual shares. If you buy shares in the FTSE 100, you’re effectively buying shares in each of the listed companies. To buy individual shares in each company would be very expensive.
Trading indices can offer a far greater degree of diversity. You can spread your money across multiple indices, which also spreads the risk. If you place all your eggs in one basket by buying shares in a limited number of companies, the risk is far greater.
Risk Management
Stocks often rise and fall based on news reports, politics, financial statements, etc. If a company’s shares take a nosedive because they were caught hiding toxic assets in the Cayman Islands, it will have a dramatic effect on the company’s share value, and not for the better!
When you trade on indices, you are betting on whether the value of the indices will rise or fall in the same way forex traders bet on whether a currency pair will rise or fall in value. If you sell an index at a higher price than you bought it, you make a profit and vice versa. When the price of an index rises, more investors are buying than selling.
Whereas stock prices in individual companies reflect the performance of that company, indices reflect wider market sentiments. For example, the day after Theresa May called a snap election, the FTSE 100 had fallen by 180 points, which saw £45.7 billion wiped off valuations.
In most cases, trading on indices is less risky than investing in individual stocks and shares, but there are always exceptions to the rule. For example, the Dow Jones fell by 22.6% on Black Monday in 1987, so never rest on your laurels.