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What is a stock index?

You have learnt by now that with our models it is possible to beat the market. In other words, it is possible to beat index. But what is even an index? What good does it do? If we can just buy individual stocks, why do we need to know about indexes?
The first lines on Wikipedia have this to say about indexes:

stock index or stock market index is a measurement of a of the [sic] stock market. It is computed from the prices of selected stocks (typically a weighted average). It is a tool used by investors and financial managers to describe the market, and to compare the return on specific investments.

This is a quick explanation, but let’s dive deeper. An index doesn’t only have to be a tool for measurement – a lot of people buy products based on indexes because they feel that it is a safer way to place your money.

What an index is

An index is a composite of different stocks. In theory you could take two stocks, show their average price and call it an index. But typically, an index consists of more stock than that. The point is to try and show some sort of general trend in the market. Nasdaq 100 shows the top 100 stocks of the Nasdaq market, that are not financial companies, calculated based on their market capitalizationMarket capitalization refers to the total dollar market value of a company's outstanding shares. Com... (with some additional rules, but that is the basis of it). Other famous indexes are the S&P 500 and the Dow Jones Industrial Average. Most of these big indexes aim to give an indication of whether the complete markets are trending up or down – but there can be specific indexes for specific measurements. The bottom line is that an index is a collection of several stocks.

How to use an index

1. First of all, we need indexes as they are a definition of the market. By following an index, you can spot trends in the market. Is it going up, down or sideways?

2. Secondly, the index gives you an assessment of how well you are doing in your own portfolio – something to compare to. But beware of tracking error! (More about this below.)

3. Thirdly, you can buy products that track the indexes. Most commonly index fundsAn index fund is a type of mutual fund with a portfolio constructed to match or track the component... that buy into the individual stocks that make up an index. That way you can get exposed to a big part of the stock market with a small investment. This is not a bad idea. You will get the market return, less any fees. But you are not on this site to get market returns. You are here to beat the market.

Think long term

We construct portfolios that are very different from the overall market or any index. Our portfolios are built on factors that have shown to beat the market over time, but not every one, two or three-year period. This means the portfolio may underperform an index for a while. It’s called tracking error. It may give you an illusion that the strategy has stopped working. Even the greatest money managers oftentime underperform the major indices for long stretches of time. That is fully expected following any investment strategy. The key to success is not deviating from the strategy (style drift) because you get frustrated or bored.

Stick to our strategy and you will find that investing doesn’t have to be hard at all. When you are with us, you won’t have to care about indexes. Try our Premium feature today.