Indexes and Your Investments: An Introduction
The Dow Jones Industrial Average reached 20,000 in January, and at the time of this writing, it is well on its way toward 21,000. What does an index really represent, and what does it mean to you as an investor? We will be tackling these questions over the next few blog posts in a multi-part series devoted to market indexes and the index funds that track them.
What’s an index?
Indexes are a combination of securities that track a particular market segment. An index is considered a representative sample of a market, so when an index does well on any given day, it’s a good bet that the market itself—and other stocks in that market—are doing well, too.
Types of index providers:
The Dow is a stock market index composed of 30 large, publicly owned U.S. companies. In addition to the Dow, which is one of the oldest and most well known indexes, there’s the Standard & Poor’s 500 index, which includes 500 U.S. companies across a multitude of industries, and the Nasdaq Composite, which is an index of all the stocks listed on the Nasdaq stock market.
There’s also the Russell 2000, an index of 2,000 small-cap companies, and the Wilshire 5000, which encompasses every publicly traded U.S. company. And those are just the most popular indexes in the U.S.
Elsewhere, there’s the Nikkei 225 (Japan), ASX 200 (Australia) and the FTSE 100 (U.K.), to name a few.
Why we use indexes
It would be challenging to track individual stocks on a daily basis. There are around 4,000 of them traded in the New York Stock Exchange and Nasdaq, and another 15,000 U.S. stocks trading on smaller markets. That’s why we use indexes, which help reduce all the unmanageable specifics into an easy-to-understand glimpse of current market conditions. Indexes do not, however, perfectly replicate the market it’s meant to represent.
Historically, indexes were created as benchmarks to shed light on how a market segment and the economy driving it was faring. Indexes also allow investors to see how their own investments compared to that market.
These days, investors continue to use indexes as a benchmark for their investments, but they can also ride the market by investing in an index fund. These publicly available index funds are essentially mutual funds designed to track an index, offering broader market exposure and lower fees to investors.
In 1976, John Bogle launched the Vanguard 500 Index Fund, the first publicly available index fund. Bogle’s underlying concept was the idea that time, money and energy was being wasted by investors and fund managers attempting to beat the market, so why not simply earn returns on the market’s natural gains over the long-term with lower management fees?
How not to use indexes
Index milestones, such as the Dow surpassing 20,000, are not indicative of whether it is a good or bad time to buy, hold or sell investments. Many investors make the mistake that these milestones are a sign to sell, but what an index is doing on any given day or month should not interfere with a well-planned investment strategy. Indexes are a great way to build a low-cost, diversified portfolio with steady gains over the long run, but counting on market timing or arbitrary milestones can detract you from your ability to build wealth as a disciplined long-term investor
Be on the lookout for more insight as we dive deeper into indexes. In future posts, we’ll talk more about index funds and their place in a long-term wealth management strategy.