PART 2: Anatomy of an Index

What is an "index", anyway? Indexes are used to measure of the overall economic health of a particular market segment. Indexes are not investments: instead, they act as a yardstick or “benchmark” to measure the performance of a particular investment or strategy against. Professional analysis firms create indexes as a way of helping investors and investment managers to keep tabs on how a group of stocks from a particular industry or exchange are doing. They each use a special criteria to “screen” for only those stocks that meet their standards.

For example, the firm Standard & Poors selects 500 of the largest U.S. companies, each which must have at least $3 billion in stock, for its well-known “S&P 500” index. The S&P 500 is one of the most widely used and respected benchmarks of U.S. stocks in the world.

There are even non-stock indices for things like bonds and real estate. Index investing therefore allows you to easily 'diversify' or 'spread out' your investment dollars over many different asset classes and individual companies.

So which index is "best"?

An index should fill an asset class need in your portfolio. But beware! Choose indices widely accepted and used. Every so-called 'index' fund is not necessarily worth investing in. The disciplines used in screening securities vary widely: some firms even create indexes solely to use with funds they also have created. According to industry experts, index methodology for these types should be both 'transparent' and 'public' (meaning understandable and displayed on their web site) and if it isn't, you should be wary.

 

Diversification made easy Spreading out your risk. There are indexes based on all major U.S. and most foreign country stocks, bonds, real estate, and other investments. Using and index fund makes it possible for an investor to easily and cost-efficiently own hundreds— or even thousands—of securities across broad market segments on a global basis. Stock investing involves risk, but one way to minimize the risk is to invest in many stocks over a variety of industries or market segments. But this diversification can be expensive, unless you use an indexing strategy. For example, rather than incurring costs for buying 2000 individual U.S. stocks, you could buy just 1 share of a Russell 2000 index fund.  Index funds for investing An index isn't an investment. An index is really a concept - a way of measuring performance - and not an investment vehicle. However, the idea of owning a portfolio of stocks that have been 'pre-screened' by professional analysts as being representative of a certain industry or market segment is very appealing. Index mutual funds and index exchange-traded funds were created to do just that. These are investments you can own. Index fund managers buy a bit of each stock listed in the index, replicating its composition as exactly as possible. This discipline costs less to manage and has a clear objective.

[1. Why indexing?] [2. Inside an index] [3. Evidence it works] [4. Making the choice]