The world of investing is the world of endless choice. You can choose to invest your money in one of many different types of instruments – for example, deposits, bonds, equity, etc. You may also allocate your money to any combination of these instruments. Further, you have thousands and thousands of bonds and shares and deposit opportunities to choose from. In this world of endless choice, how do we assess various choices? In other words, can you judge which investment is good and which is not?
Beating the Market (and Stock Indices) Explained
You may have come across statements like “Warren Buffet has consistently beaten the stock market” or “this fund has beaten the stock market three years in a row”. Beating the market is one measure of how well a particular investment portfolio has performed – to beat the market means to have outperformed the market index. This leads us to another question – what is a market index? A stock market index is simply a measure of the value of a group of stocks.
Suppose you take a group of 10 stocks in a market. The value of these 10 stocks together can be represented through an index. Suppose we construct an index that represents the sum of the values (i.e. the prices) of 1 share of each of these stocks today. So, we assign a number, for example 1,000, to the index to represent the value of these stocks today. In the next one month, suppose the value of these stocks together goes up by 10%. In this case, we will say that the index is now at 1,100 (i.e. 1,000 + 10% of 1,000).
On the other hand, suppose the value of these stocks together goes down by 10%. In this case, we will say that the index is now at 900 (i.e. 1,000 – 10% of 1,000). This is a brief illustration of how a stock index works. In this case, the index represents the value of 1 share each of 10 different stocks. Do note that it is not necessary that each of the components of the index have equal weight.
For example, we can just as easily create an index based on the values of these 10 stocks where the price of one stock (say stock A) has 50% weight in the index, the prices of 4 other stocks have 10% weight each in the index and the prices of the remaining 5 stocks have 2% weight each in the index. In this case, the index will be more sensitive to changes in the price of stock A than to changes in the prices of the other 9 stocks. Similarly, the index would be impacted more heavily by changes in the prices of those 4 stocks that have 10% weight each on the index than by changes in the prices of those 5 stocks that have 2% weight each on the index.
Another point to note is that if a stock market index gains in value, it does not mean that all the stocks that are a part of that index have uniformly gained value. It is possible that some stocks may have lost value, some may have neither gained nor lost value and still others may have gained value. The index only tells us whether the value of the stocks together has increased or declined. It does not tell us anything at all about any of the individual stocks.
Do note that there can be many different kinds of stock market indices. For example, MSCI World and S&P Global 100 are two well-known world (or global) indices. Such indices typically track large companies across the world. These indices provide a measure of stock market performance across the world, i.e. they provide a quick indication of how stock markets (taken together) across the world have performed (whether they have gained value or lost value).
Regional indices, such as FTSE Developed Europe Index, FTSE Developed Asia Pacific Index, etc., reflect stock market performance across various regions or parts of the world. Such regional indices typically cover areas larger than a single country. They may encompass an entire continent or parts of different continents or groups of continents.
National indices, such as USA’s S&P 500, Japan’s Nikkei 225, Britain’s FTSE 100, etc., typically include large companies from the biggest stock exchanges across the country. Some indices, such as NASDAQ-100, NYSE 100, etc., may focus only on one exchange. Similarly, there may be indices that focus only on particular sectors within a stock exc