mdphoto16 / Getty Images Common indices include:
S&P 500: Tracks the performance of stocks of 500 of the largest companies across various industries in the U.S.Russell 2000: Tracks the performance of the 2,000 smallest publicly traded companiesMSCI EAFE (Europe, Asia, Far East): Measures the performance of stocks in developed countries outside of the U.S. and Canada.Dow Jones Industrial Average: Tracks the performance of 30 companies from different industries representing the largest and most widely held publicly traded companies in the U.S.Consumer Price Index: Tracks inflation based on changes in prices in the consumer market.
How an Index Works
A theoretical example might help to illustrate this. Suppose we created an index to track the price of a gallon of milk.
When we start tracking, let’s say milk costs $2.00 a gallon.The starting index value is 1.When milk goes to $2.50, our index goes to 1.25, which reflects a 25% increase in the price of milk.If milk then goes to $2.25, the index goes to 1.15. The .10 change reflects a 10% decrease in the price of milk.
If you were a milk dealer, you might find a milk index useful. Instead of going to the store each day to write down the prices of each competitor’s milk and averaging them together, the index would provide that data for you. Stock market indexes are used by traders, economists, and academics. Each uses the information in a different way. For the average person, the day-to-day change in the stock market should have no relevance to their life, so why pay attention? Most people should develop a long-term investment plan that uses index funds, which own all the stocks listed in an index. This allows you to leave your investments alone for years and not obsessively watch the market.
Types of Indexes
One of the most important things to understand about any given index is how it is weighted. There are a variety of different methods for weighting indexes, but here are some of the most common:
Price-weighted indexes: Each stock’s proportional share in the index is based on its share price. Value-weighted indexes: Each stock’s proportional share is based on its total market capitalization (share price times outstanding shares). This is also known as a market-capitalization-weighted index. Unweighted indexes: Each stock has an equal value within the index as a whole.
How You Can Use an Index in Investing
Sometimes it’s hard to know how well your portfolio or financial advisor is performing. You might hear numbers like 3%, 5%, or 10% growth but what does that really mean? Are those good numbers? The answer is, it depends. Some years the investment markets have a great year and go up by double-digit percentages. Other years, those same markets might only see 1% growth or even declines. You should measure the performance of your portfolio or financial advisor against an index. Aside from simply investing directly in an S&P 500 index fund, you could compare your entire stock portfolio to the S&P 500. If that index rose 9% in a certain year, you might expect your stock portfolio to rise 6% or more. (Most portfolios are a little more conservative than the index, and there are some fees involved.) If your portfolio outperforms the index, congratulations. But if your portfolio consistently underperforms the index by a large margin, that’s a good reason to ask some questions. Every portfolio will have years where it outperforms or severely underperforms an index. You should only be worried if it underperforms over multiple years.
Pros and Cons of Indexes
Pros Explained
Useful tool for gauging a particular market’s performance: Market indexes provide a fairly accurate assessment of how that particular sector is currently moving. Provides a good baseline for investment comparisons: You can assess your portfolio against an index to see if it is performing up to your expectations. Helpful for market forecasting: Economists and investors can look at how different indexes responded to particular market forces in the past to predict how they might respond in the future. A less expensive investing option: Because index funds passively follow their market index, they come with fewer fees.
Cons Explained
Different systems for weighting and calculating index funds: The variety of weighting methods can make it difficult to understand how different indexes might behave.Lack of investing flexibility: If you invest in index funds, you’re stuck with however that particular index performs and unable to adjust as you see fit.Lower returns than actively managed funds (sometimes): In some cases, actively managed funds will outperform indexes because you or your investment advisor can adjust on the fly.
