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What Is An Index?

Do you have money in an index fund? Do you even really know what an index is? I’ll explain what an index is so you can better understand your investments.

Most common sense investing advice for non-professional investors says that you should buy an index fund and sit on it. You tend to get reduced fees, historically active stock picking hasn’t outperformed the major indices (or indexes, both work), and it’s less work for you to manage.

It’s fairly solid advice and with companies like Vanguard or Betterment it’s easy to do, but do you actually know what you’re buying? If you know what an index is, do you know how it’s put together? Let’s dive deeper in to those topics.

Indices Defined

The major US indices that you hear about on the news are the Dow Jones Industrial Average (Dow/DJIA), the NASDAQ Composite, and the S&P (Standard & Poor’s) 500. One thing to keep in mind with each of these indices is that the member companies can and do change.

This helps partially explain why the market is always moving because if a company is no longer very relevant to the economy, it’s dropped and something more relevant replaces it. However, if you own an investment vehicle that matches an index, you get the benefit of the change without having to do the work of selling and reinvesting.

Before we go deeper in to the different indices I want to cover a couple of terms that will help make this article make more sense:

Market Capitalization– Often shortened to market cap, it’s a strong indicator of company size. Measured by multiplying the number of outstanding shares (stock owned by shareholders) by the current price of the stock.

Blue Chip– large, high quality companies. Investopedia has an interesting write up on the history of the term.

The Dow

The Dow is made up of thirty companies with a price weighted average. It only looks at thirty companies because back in the day (it was founded in 1896) you had to do all of the calculations by hand and they thought twenty (changed in 1928 to thirty) was a good enough representation without having to do a crazy amount of work.

You took the price of the thirty companies, added it together, and divided by thirty. The process is slightly different today because the calculation includes a divisor that is adjusted for new companies joining the index with a different price than the one they’re replacing and to account for stock splits, which would cut the companies price by the split multiple.

Today, you have indices like the Russell 3000 or Wilshire 5000 which take advantage of the fact that computers are better at math to survey broader segments of the total market. Back to the price weighted average- it means that the company only considers the price of a stock and not its market cap.

With a price weighted index, a $1 change in a $600 dollar stock has the same impact as a $1 change in a $10 stock even though one is clearly a larger percentage change in value than the other. Even though the Dow is the most reported on index, price weighting is generally viewed as an inferior way to measure market activity.

When you think about it that makes sense because a 10% drop in Apple (price $112, market cap $640 billion) would matter a lot more to the economy than a similar drop in Priceline (price $1,312, market cap $67 billion). It’s still a useful index but not as representative of the entire economy as I’d like.

S&P 500

I like using the S&P 500 as my benchmark more than the Dow. As you can certainly guess from the name, it looks at substantially more companies than the Dow though it’s named slightly incorrectly as it actually looks at 505 companies.

While 505 companies is clearly only a small portion of the total number, the S&P 500 includes most of the largest companies and accounts for about 80% of the total market cap. Therefore, unless you’re looking to invest in much smaller companies, it’s a good indicator of how large cap companies and the market as a whole are doing.

The second reason I prefer the S&P 500 over the Dow is that it’s a market weighted index. This means that it compares the market value of the member companies day to day and changes in the index are in proportion to the size of the companies.

In this case, a 10% decline in Apple would have a much larger impact than a similar decline in Priceline. The major benefit to you the index fund buyer is that the changes in a market weighted index actually reflect the change in value that you’d get if you were holding all of the underlying stocks.

NASDAQ

The NASDAQ Composite index is the final of the three major US indices. It includes all of the securities listed on the NASDAQ exchange, which is the second largest exchange in the world behind the New York Stock Exchange. It was the first electronic stock market,the first to allow online trading and now contains the majority of the large tech companies.

Therefore the NASDAQ composite is viewed more as a tech index, though the companies on the NASDAQ are also some of the largest in the world and are therefore included on the other indices. It’s also a market weighted index so it’s a better representation of the actual underlying companies than the Dow.What-Is-An-Index

Conclusion

Hopefully this gives you a bit more understanding of what it is people are talking about when they say you should buy index funds. Those funds pool your money to buy all of the underlying companies in the same proportions as the index they track, which would be impossibly expensive for most investors.

However, it is highly diverse and gives access to most major industries and most of the market. Buying the index allows you to buy easy diversity which is very good for your portfolio. It does limit you to the aggregate performance of all of the companies which means you’ll have winners and losers each year and you are unlikely to hit any major home runs with this strategy.

It’s not like buying Google at its IPO. However those home runs are few and far between and only obvious in hindsight so your strategy shouldn’t be geared towards that unless you’re already incredibly wealthy.

If you’re a normal person like me just looking to get solid returns over time and slowly build up your portfolio then you should read, understand, and act. Please let us know in the comments if there’s anything else on this topic you’d like covered.

We’ve also got a list of the best Vanguard funds that we know about – you should check them out.

Featured Image Photo Credit: “Wall street bull” by htmvalerio on Flickr

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