The History of the Stock Index and Its Lessons for the Crypto Markets
It may come as a surprise, but cryptocurrency trading today has a lot in common with the early days of modern-era stock trading back at the beginning of the XIX century. In both cases, regulation is lax, and markets are prone to manipulation. In both cases, certain key elements of trading infrastructure are still missing. But the biggest similarity is the overall retail investor sentiment — both modern cryptocurrency enthusiasts and stock operators of old lean towards high risk — high return investments and prefer active trading strategies (even the least informed and market-savvy among them).
Stock markets today are a very different environment — investors that don’t have the time or ability for constant market monitoring use long-term passive strategies or rely on professional services of asset managers. So, what has happened in the last 150 years that has changed the investors’ behavior so drastically?
Arguably, the pivotal moment was the invention of the stock index. Serving as a benchmark to measure the success of one’s investments, it ended the “gold rush” mentality among investors. Trying to maximize potential profit on every single investment was no longer the ultimate goal — many market participants started to prefer a more risk-averse and “hands-off” approach, which provided a boost for the asset management industry. It is logical to believe that the introduction of cryptocurrency indices will lead to a similar market development. Today we look back at some of the key innovations behind the idea of a market index and how it changed the nature of investing.
Charles H. Dow, a finance journalist, unveiled the first stock index in 1896. His Dow Jones Industrial Average was an average of the top 12 stocks in the market. As this was just at the tail end of the industrial revolution, the majority of these companies were in the industrial sector (steel mills, railroads, mining, etc.). He calculated the DJIA by taking all of the stock prices, adding them together and then dividing them by the number of stocks. The number that came out of this equation on May 26, 1896, was 40.94. The range of the Dow has since been expanded. From that moment on, the investors had an indicator that served as a proxy for the market in general.
Even more importantly, Charles Dow pioneered the use of financial indices in market analysis and investment decision-making. His “Dow Theory” can be regarded as a precursor to modern technical analysis.
As stock markets developed in early XX century, it became apparent that an average was not the optimal methodology for index calculation. This led to the creation of the generation of market-weighted indices that used company market cap as weights, ensuring that the company’s relevance to the index was in proportion to its size. This is the same methodology we use for calculation of Zichain index family. Curiously enough, the full-scale implementation of market-weighted indices was postponed for a couple of decades due to lack of computational power needed to update them regularly. In 1946, Standard & Poor bought a punch card computer from IBM and was suddenly able to expand the index from 90 to 500 companies, which could be updated hourly. The resulting S&P 500 index still serves as the main indicator of the American stock market even to this day.
The next important innovation pertaining to the financial index took place in the 1990s with the introduction of the ETFs (Exchange Traded Funds). Just like the name implies, those were traded on exchanges, making them a convenient solution for investors looking for a ready-made strategy packaged as an ETF. A large proportion of ETFs is comprised of index funds, tracking a particular index and mimicking its composition in their portfolios.
Looking back on the history of their application on the stock markets, we believe that introduction and widespread use of cryptocurrency indices will have a profound effect on the digital asset markets, ending their current speculative phase and leading to a more mature and diverse environment.