An index is a statistical representation of the collective price of a group of investments, such as like-sized companies.
A stock or bond index is meant to show investors how an overall investment market has performed over a specific period of time. An index allows for a comparison of past, present and future values and thus relative changes in value.
That data in turn allows investors to compare other investments against the index.
The managers of a stock mutual fund, for example, might be able to point out that their specific investments or decisions to buy and sell allowed the fund to exceed the return of the overall market, as represented by an index.
Index construction is complex and is undertaken by private firms. These firms use advanced techniques to track price changes of dozens or hundreds of stocks and bonds.
The resulting data is published as a single number, referred to by the index’s name.
When investors say they “beat the market,” what does that mean? It means that the return they experienced on their selected investments created a return greater than a comparable group of like investments.
For instance, a large-cap stock investor might buy a few dozen shares of 10 companies. He proceeds to trade those shares throughout the year, carefully recording gains and losses and subtracting costs created by trading, as well as adding back dividends collected and perhaps reinvested.
At the end of a period of time, usually a year, our active investor can do a calculation that compares his starting point in dollars to his ending point.
The percentage change in dollars is either an investment gain or a loss.
Armed with this percentage figure, the investor can then compare it fairly to an index that tracks large-cap stocks, such as the S&P 500 Index or the Dow Jones Industrial Average.
If the return experienced by the investor is greater than the market index after costs, he can say he “beat the market,” and rightly brag of his prowess as an investor.
Similar comparisons are made by technology stock investors against the Nasdaq, by bond investors against the U.S. Aggregate Bond Index and by foreign stock and bond investors against various indexes produced by MSCI.
Over long periods of time, however, it can be difficult to maintain a record that exceeds the return of an index after costs. One year of bad returns can drag down the long-term average.
The cost of active trading is a drag and must be accounted for in any accurate comparison. If you invest through mutual funds, the fees charged by the managers of those funds also subtract from your investment return.
Fees and costs are a big reason why so many investors have chosen to invest instead using index funds, which track the major indexes using a computerized trading system at a very low cost.
Using in a risk-adjusted portfolio and rebalancing periodically can add to long-term return while keeping risks minimized, the preferred method of many pension funds and university endowments.