Stock index: what is it and why should you try to outperform it?
Probably every person who has ever thought about investing has heard the short and unambiguous advice that you should invest in indices. The well-known S&P500 is on the pedestal of popularity in this regard, being to some extent the gold standard and perhaps the first association with the US stock market. So, let's take a look at what a stock index is, its role and importance, and why you should outperform it.
What is a stock index?
A stock index is a numerical value that reflects changes in the average level of share prices within a certain group of companies on a stock exchange. A stock index can consist of the values of shares in a particular sector of the economy, a particular region or country, or the entire global stock market. A stock index is an excellent analytical tool that allows you to assess changes in the market situation and notice certain correlations between assets. The most famous stock indices are the Dow Jones Industrial Average, NASDAQ Composite, and S&P 500.
Most experienced traders and investors perceive stock indices as valuable tools for analytics or for direct investment in them, but it is worth reminding that there is a difference between an index, ETF trading, and index futures contracts. The difference is quite significant, given the fundamental difference between trading stocks and futures contracts - the former provides more flexible conditions and has a lower risk potential.
How and by whom indices are created
As you know, the first stock index is the Dow Jones Industrial Average (DJIA), which was created in 1896 in the United States by Dow Jones & Company. Initially, the list included shares of 12 large companies in the industrial sector.
In today's world, stock indices are created by financial organizations and companies specializing in investments. However, there are no specific guidelines and rules on how an index should be created and what stocks should be included in the list. In other words, it can be said that the formation of an index remains the responsibility of the organization that creates it, and the authority of the “creator” is of great importance.
Of course, the process of creating indices can by no means be called chaotic and inconsistent, as there are several basic approaches to the formation and calculation of indices. Let's take a closer look at the calculation. Three calculation approaches are the most common: the capitalization method, the price weight method, and the equilibrium method. Each of the methods is different and if you plan to use indices as analytical tools, you should definitely distinguish between the fundamental differences in their formation. For example:
1. The capitalization methodology involves calculating an index based on a company's capitalization, i.e., a larger capitalization equals a larger contribution to the index. The most famous example of an index created using this method of calculation is the S&P500, which we will mention more than once in this article. Let's take 2 companies included in the index as an example: Apple Inc. (AAPL) and Johnson & Johnson (JNJ) with a capitalization (at the time of writing) of 2.54 trillion and 433 billion US dollars, respectively. According to this methodology, the weighting of the two companies in the index differs by almost 6 times.
2. The price weight method is a method used to calculate an index based on a share price. The logic behind the calculation is quite simple: the higher the share price, the greater the value of the stock in the index. This is how the Dow Jones Industrial Average is calculated.
3. Equilibrium method: The main feature of this method is that each constituent has exactly the same weighting, regardless of capitalization or share price. One of the most famous examples of such an index is the S&P 500 Equal Weight Index. In fact, it is the same well-known S&P 500, but it is calculated equally, regardless of the size of the company. Thus, this index provides a more equal distribution between companies and less dependence on a few largest companies that determine the main direction of the index.
There are many discussions about the advantages and disadvantages of each calculation, but the main thing to remember is that the diversity allows you to choose the right tool for your needs.
Indices as investment instruments
Undoubtedly, in addition to their analytical value, indices are often used as benchmarks in the context of investments. There are several good reasons for this:
An index can be the basis for a diversified investment strategy. It is diversification that makes it possible to balance the potential returns and risks of investments, i.e., if the value of one stock falls, the potential growth in the value of another stock can compensate for the loss.
Indices often have stable and long-term growth, which makes them attractive to long-term investors who have a somewhat conservative approach. For example, the S&P 500 (SPY) has grown by an average of more than 10% per year over the past 50 years. This effect is achieved, among other things, by rebalancing the index - the process of redistributing and updating the list of stocks and their weight in the overall composition of the index. This process usually takes place at certain intervals and allows you to maintain or even increase the profitability of investments in a stock index.
Investing in indices is a fairly quick and affordable way to invest, as it allows you to buy shares of an index fund and not spend time analyzing and tracking each individual asset on your own.
And finally, let's return to the promising question in the title of the article: why outperform a stock index?
In the investor community, it is believed that the goal of a well-diversified portfolio is usually to outperform the major composite indices - the Dow Jones Industrial Average, NASDAQ Composite, and S&P 500. The rationale behind this view is that the time and resources invested in trading and investing should yield a better result than the return on the index, because if the result is lower or equal to the return on the index, then it is obvious that investing in the index would be a simpler and more affordable solution. Over time, this statement has even acquired a certain humorous meaning, but still remains popular in the industry community. In fact, there are even separate approaches and formulas for calculating performance that make it possible to determine whether an investment manager has achieved better results than the selected market index. For example, the Jensen index calculation formula provides an indicator - the alpha coefficient, which is a measure of portfolio management efficiency. The formula for calculating the Jensen index is as follows:
Jensen's alpha = Rp - (Rf + beta x (Rm - Rf))
Where:
Rp is the annualized return of the portfolio;
Rf is the risk-free rate of return for the same period;
beta is the portfolio's beta coefficient, which reflects its sensitivity to market changes;
Rm is the annualized return of the market for the same period.
If the calculation result is positive, the conditional portfolio management is efficient, i.e., more profitable than the index; if the result is negative, it is inefficient.
So, to summarize, stock indices are an important and valuable component of trading and investment. To a certain extent, they simplify the understanding of what the market is, the general situation on it, and its value to the world. Remember that you should never be disappointed if at the beginning of your journey in trading and investments the return is less than the index return, because it is the process and the formation of your own unique path in the extremely dynamic and full of opportunities industry of stock market trading that is of great importance.