What are Indices?
No matter what kind of investor you are, it never hurts to take some advice from one of the most successful investors of all time.
Both large and small investors should stick with low-cost index funds.
Of course, following Buffet’s advice would be near-impossible, if you don’t know what an index is.
Outside of the stock market, an index is usually encountered at the end of a book and is usually just a list of citations or bibliographical information. An index can also be an indicator or a sign of something. An index in the stock market however, is both a list and an indicator.
In the stock market, an index is a list of stocks that can be used to represent a certain industry. These lists are compiled so that analysts can measure macro-statistical changes in the market. These statistical changes can give investors a bird’s eye view of things and in some cases, signify future movements in the market.
Basically, to get a view of how the market is doing, analysts compile an index of relevant public companies and then average either their stock price or market capitalization. These averages are vital to investors because they provide the first warning signs of a bear market as well as providing investors some time to set up for an incoming bull market.
The first ever stock market index was made by Charles Dow, called the Dow Jones Industrial Average (DJIA). In its advent on May of 1896, it was a compilation of the 12 largest publicly traded companies in the United States. Today, it includes the 30 most influential companies in the U.S., representing roughly 25% of the value of the North American stock market.
By taking a peek at the DJIA’s statistical data alone, an investor gains a sweeping perspective of the U.S. market without having to look at every individual American company. Utilizing the information from indices allows a trader to save a tremendous amount of time that can be used to do further research.
The Stock Market’s Dark Horse: the Index Fund
One of the most well-known indices in the world is Standard & Poor’s 500 (S&P 500) and it is a list of 70% of all publicly traded companies in the U.S. It is also Warren Buffet’s index of choice when it comes to index funds.
“Over the years, I’ve often been asked for investment advice,” Buffet wrote in his 2016 letter to his shareholders. “My regular recommendation has been a low-cost S&P 500 index fund.”
As you may have already inferred, indices are more than just vehicles of statistical information and that they can also be used as an alternative to standard investment strategies. This alternative comes in the form of index funds.
In order to figure out what index funds are, it is first necessary for us to look at a certain index’s yearly return. The S&P 500 for example has an average yearly return of 10%, which is more than what most actively managed mutual funds can achieve.
This isn’t limited to the S&P 500 either, most indices do have analysts beat when it comes to yearly returns. The fact that most indices outperform mutual funds isn’t a breakthrough by any means. Academics have long known about this occurrence and they have even gone as far as developing a theory around it, called, the Efficient Market Hypothesis (EMH).
With this in mind, it’s quite obvious that indices provide a relatively safe and yet oddly profitable opportunity to traders. This is why in 1975, John Bogle created the very first low-cost mutual fund that invested not in specifically chosen companies, but in the companies that make up the S&P 500.
Bogle started a trend that continues until today, albeit index funds are somehow relatively unpopular compared to standard investment strategies. The reason behind this is the fact that index funds are passively managed. This means that no research and analysis is involved in this strategy, mainly because the fund merely mirrors the index of its choice.
Humans want to be the master of their own destiny after all. There’s also a certain degree of romanticism in making money out of your own research-backed decisions. In fact, Warren Buffet himself doesn’t follow his own advice, having propelled Berkshire Hathaway to the very top using his own analyses.
Still, it would be a wasted opportunity to not include at least one low-cost index fund in your portfolio. After all, there are only so few low-risk, high-profit investment opportunities in the stock market.
Indices to Watch Out For
Dow Jones Industrial Average (DJIA) -These are natural resources that require mining or drilling, like: gold, silver, oil, and copper. These commodities tend to have long shelf lives which means they can be stored for a long period time. Hard commodities are also used as a baseline for the health of the global economy due to the reliance of most economic sectors in these goods. Hard commodities are also relatively stable due to the consistency of mining and drilling operations.
Standard & Poor’s 500 (S&P 500) -One of the world’s best benchmarks for companies with massive market capitalizations. Most fund managers use the S&P 500 as a reference point because of its accurate representation of the U.S. stock market. The index unfortunately is light on foreign content and incredibly top heavy, with 45 companies contributing to more than half of the index’s value.
Nasdaq Composite Index – Composed of mostly tech companies, the Nasdaq Composite rose to prominence thanks to the technological take-over of the market that’s currently in progress. Since tech companies are relatively volatile, this index shares their volatility, making it a risky bet for index funds.
Wilshire 5000 Total Market Index – Known as the ‘total market index,’ The Wilshire 5000 has a whopping 3500 stocks under its belt, making it the most comprehensive index in the U.S. market. It shares the same problem with the S&P 500, however, being very top heavy, with 10% of all the companies in the index accounting for roughly 75% of its value.
Russell 2000 Index – The Russell 2000 is special in that it focuses on indexing companies with smaller market capitalizations. It is a vital index that holds valuable information that would have slipped through the cracks if not for its existence. Since companies with smaller market caps usually aren’t established yet, this index can be quite volatile.
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