Methodology

Investing Basics

Module 2

What is a portfolio?

Stock Market Indices

A stock market index is a group of companies that are all listed on the same stock market. An index is formed as a way for investors to track the performance of a specific group of stocks.

There is no limit on the number of stocks that can be included within an index. For instance, the most famous indices are the S&P 500, FTSE 100 and Nikkei 225, which include 500, 100 and 225 companies.

It can even be the case that an index can be formed using stocks from different countries. The MSCI World Price Index is a global index that includes stocks from the largest companies in the world. It features companies from the United States, UK, China, Japan, Canada and Europe. 

Stock market indices can be created based on a number of different characteristics. The most common characteristic is size, where an index will include the largest companies on a particular stock market.

Can you invest in an index?

It is possible to invest in an index, as many investment companies have created funds that match holdings of an index.

Companies like Vanguard and BlackRock are the most famous in this particular area. The Vanguard S&P 500 is one of the most well known index funds.

Investors can usually buy into an index fund using a stockbroker or their bank, just like they would with any other type of investment. Alternatively, it can even be possible to invest directly with the company that offers the index fund product.

For instance, if you visit the Vanguard website, it may be possible to invest directly with them, via their website.

Index funds are a great option for new investors that have little experience. As there are usually so many stocks in an index fund, they act as very well diversified portfolios for new investors.

With index funds having so many stocks, they are stable investments that deliver consistent returns. For example, the S&P 500 is famous for consistently delivering an average return of 10% a year, over the last one hundred years.

Using an index to measure performance

Stock indices are useful for investors because they can be used as a benchmark to measure the performance of their own portfolio.

If an index fund performs better than the portfolio of an investor, then there is little justification for an investor to keep investing in their portfolio.

Instead, the investor would be better off investing in the index fund that they have benchmarked their portfolio against. Although it is considered to be very difficult, it is common for investors to try and out-perform a specific index.

Picking the right index to use as a benchmark is important. Investors should try to use a benchmark that is similar to their own portfolio.

For example, if an investor mostly allocated capital towards large American companies, then it would be sensible to use the S&P 500 as their benchmark.

However, if an investor was mostly investing in Japanese stocks, then the S&P 500 would be unsuitable. Instead, the Japanese index would be more appropriate (Nikkei 225).

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