Investing 101: Indexes

(Welcome once again to my ongoing feature, Investing 101.  This week, we’re looking at indexes, those things whose prices you hear quoted at the end of most business news reports.  But what are they, how do they work, and why does everyone seem so concerned about this ‘Dow Jones’ guy?  Read on for the exciting answers to these and other questions of vital importance!)

Q: So what is an index, anyway?

A: An index is simply a collection of stocks, bonds, or other individual investments.  Depending on the particular index, it can represent the entire market or some smaller portion, divided up according to index creator’s criteria.  You can think of them as imaginary portfolios holding the particular investments that it tracks.

Q: Alright, why should I care about indexes?

A: Well, if you are investing in index funds, where the mutual fund company attempts to own all of the stocks in the index (or a representative portion, in some cases), then indexes should be quite familiar to you.  They serve as the basis of your funds’ holdings.  You can thus use the performance of the index (which are frequently reported in newspapers) as a proxy for your investment performance.  (Although, it’s worth mentioning that your index fund will (almost) always lag the performance of your index; real mutual funds have expenses while indexes themselves do not.  Still, your fund should perform roughly the same as the underlying index, making the index a useful tool.)

Q: That’s fine for index investors, but I buy actively managed funds and individual stocks.  How do indexes help me?

A: Well, indexes serve as a benchmark for your actively selected investments.  If you own an actively managed fund (or attempt to manage your own money), you should compare your returns to an appropriate index.  If your fund is not outperforming the index (or an index fund, to take into account the aforementioned mutual fund fees) that holds the same type of investments, you should consider switching to an index fund and being done with it.  You’re paying higher fees (or trading commissions) to achieve worse results than you could get with an index fund.  (Now, of course, be reasonable with your comparisons; dropping a fund for one year of under-performance is not usually justified.  But do be sure to watch how your active investments perform compared to an appropriate index.)

Q: Alright, what sort of indexes are out there?

A: There are literally hundreds of indexes, run by numerous different companies.  There are indexes created by Standard & Poor’s, Morgan Stanley, and the Russell Investment Group, amongst others.  Three of the most commonly encountered indexes are the Dow Jones Industrial Average, the S&P 500, and the NASDAQ Composite Index:

  • The Dow Jones Industrial Average, commonly called the Dow, is composed of 30 different stocks that are among some of the largest companies traded in America.  These companies are considered some of the leaders in their fields, and the index, although limited, is considered a good representative of how American industry is doing.  It’s also the most commonly and prominently mentioned index on financial and other news programs, and thus one that’s easy to track.  For a more complete picture of how American business is doing, we can look at:
  • The Standard and Poor’s (S&P) 500 Index, which measures the performance of 500 of the largest companies in the United States.  It includes all the Dow stocks and an additional 470 stocks of large companies, making it a more complete and accurate picture of American industrial performance.  It does not include mid- and small-cap stocks, though,
  • The NASDAQ Composite Index measures the performance of the more than 4,000 stocks that trade on the NASDAQ exchange.  It tends to be weighted towards technology and other ‘hipper’ stocks (one reason why it suffered a tremendous fall at the end of the tech boom).

Q: That’s quite a list; you say there are other indexes?

A: Oh yes, indeed.  There’s the DJ Wilshire 5000, which includes all the stocks in America, making it even more representative of the American economy than the S&P 500, the MSCI EAFE, which invests in European, Asian, and Far Eastern stocks, and the Russell 2000, which invests in small- and mid-cap stocks (a total of 2000 of them, to be exact).  Which index funds (and related indexes) you should invest in and how much money you put into each one will depend on your goals, financial situation, and personality.

Good luck in the wonderful, funderful world of indexes, and see you for the next edition of Investing 101!

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