What is an index?
An index is a group of securities reflecting a securities market or a particular segment of a securities market. It is used to measure and report the fluctuations of the market or market corner it represents. As you might guess, stock indexes track the stock market, and bond indexes track the bond market. Largely because of the popularity of stocks over bonds as a vehicle for the average investor, stock indexes far outnumber bond indexes. There also are indexes for various other markets, such as commodities and currency.
Both types of indexes can help you with the process of building and running your investment portfolio. You can structure part of your portfolio to replicate a particular index, you can invest in mutual funds or exchange-traded funds that are based on a particular index, or you can simply use indexes to monitor various markets. The headings that follow provide more detailed information on various indexes, and how you might consider using them.
A stock index is a standardized composite used to measure and report value changes in representative stock groupings (i.e., a theoretical portfolio). Strictly speaking, a stock index is distinct from a stock average. While a stock average is simply the arithmetic mean of a group of prices, a stock index is an average expressed in relation to an earlier established base market value (e.g., the S&P 500 uses 1941 to 1943 as a base period). In practice, however, the distinction between an index and an average is not always clear. As a result, the two terms are often used interchangeably.
If this sounds too technical already, don't worry. When put into layman's terms, the concept of a stock index is not difficult to understand. It is simply an indicator of stock price movements. Each index targets a certain group of stocks and reflects the net result of fluctuating daily values for all stocks in the group.
An index also tracks the number of shares outstanding for companies in the index. Some indexes are broad-based in that they are comprised of many individual stocks (e.g., the Wilshire 5000) and thus are more representative of the overall stock market. Others are more narrowly based, meaning that they track a smaller number of stocks reflecting only a particular industry (e.g., automotive) or segment of the stock market (e.g., small-cap stocks). An extensive number and variety of stock indexes exist. The Dow Jones Industrial Average (which includes only 30 stocks) and the Nasdaq Composite Index are two of the most widely followed stock indexes. These and other well-known stock indexes are briefly described below.
One factor to be aware of about a stock index is its methodology for weighting each individual security—in other words, the way in which it determines how much of each individual security to include in the index. Some indexes are weighted by market cap; the companies with the highest total value of stock outstanding make up a larger share of the index than companies with a smaller market cap. As a result, those companies may have a disproportionate impact on the index's performance. Other indexes are weighted by price; the most expensive stocks receive greater weight than lower-priced stocks. Still others are equal-weighted; each company receives the same weight in the index, regardless of size.
How can you use stock indexes?
Stock indexes can have several uses for the individual investor. Most obviously, if checked regularly, they can provide valuable information needed to stay abreast of how the stock market (as a whole or a particular segment) is faring. This can help you make informed investment decisions about when and what to buy, when to sell, and so on. To make the best decisions, though, you should use indexes in conjunction with a variety of other resources. Many investors even invest in investments that track one or more stock indexes in an effort to reduce their risk and/or assure themselves of a particular level of return (though there are no guarantees).
Though it is not possible to invest directly in an index, you can do so indirectly. If you'd like to try to achieve a performance similar to that of a particular index, you can either directly copy the index on your own (by buying all of the individual securities in the index) or purchase shares of an index mutual fund or exchange-traded fund that essentially replicates the index. This latter method is generally easier, safer, and less costly for the average investor. Beyond that difference, though, these two methods of investing in indexes share the same pros and cons. Since most indexes are broad-based in terms of number of securities, they offer the advantage of extraordinary diversification. This typically means that you have an excellent chance to achieve returns that approximate market averages.
However, such investments are not without risk. Depending on market conditions and other variables, the potential always exists that even a widely diversified index-based investment could take a bad tumble; even diversification can't guarantee a profit or protect against the possibility of loss. This could happen, for instance, if an entire industry targeted by a certain index suddenly finds itself out of favor, or if a stock that dominates a particular index has difficulties. However, the diversification of index-based investments can help minimize that impact compared to investing in an individual security. The trade-off of this diversification is that returns may be diluted as well; the performance of an index's weaker components will be a drag on that of its stronger members. A portfolio that concentrates on the index's best performers could outperform the index.
Finally, selected indexes are also used as the basis for stock index futures, index options, and other instruments that enable investors to hedge against general market movement at a low cost. These latter instruments should be reserved for the most sophisticated investors, however.
Ultimately, there's no right or wrong answer to the question of whether you should put money in index-based investments. The decision is a personal one, based on your own investment objectives, tolerance for risk, and other factors. If you need guidance, consult a financial planner or other professional.
Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2018.