What is an index? Examples, how it’s used

What is an index? Examples, how it’s used
Table Content
What is an index?
Understanding indexes
Index trading
Index investing
Examples
Bottom line

That’s right - it’s time to learn about the meaning of that word you’re seeing left and right on the first leg of your trading and investing – the market index. An index is a standardized technique of tracking the performance of a group of financial assets. Indexes typically assess the performance of a basket of assets designed to mirror a specific market segment.

These could be broad-based indexes that represent the whole market, such as the S&P 500 index or Dow Jones Industrial Average (DJIA). Or, they could be more specialized indexes that follow a certain industry or area, such as the Russell 2000 Index, which measures small-cap stocks exclusively. In today’s article, we’ll look at what an index is, how they work, the difference between index trading and index investing, and some of the most commonly used indexes in the US markets.

What is an index?

In a nutshell, a market index measures the performance of a subset of stocks, bonds, or other investments. These investments are sometimes clustered around a specific industry, such as tech stocks, or even the stock market as a whole, such as the S&P 500, Dow Jones Industrial Average (DJIA), or Nasdaq.

When it comes to market indices, there is no standard size. The DJIA has only 30 stocks, whereas the CRSP index has over 3,700. What matters is that each has a large enough sample size to accurately represent the overall behavior of the economic slice that it seeks to represent. 

Understanding indexes

In order to track the stock market and manage their investments, many different types of investors use market indexes. For example, funds use indexes as performance standards, and managers use indexes as a starting point for designing investable index funds. Hence indices are deeply ingrained in the investment management industry.

Index trading

Now, there is a difference between index trading and index investing. Let’s look at how index trading works first. Index trading is simply buying and selling a particular stock market index. Investors speculate on whether the price of an index will rise or decline, which helps them decide whether they will make a purchase or sell. Because an index measures the performance of a collection of stocks, traders are buying any actual underlying stock but rather the group’s average performance. When the companies’ share prices in an index rise, so does the value of the index. If the price decreases instead, you guessed it — the index’s value lowers.

When trading indices online, you have two options: index cash CFDs and index futures CFDs. The fundamental distinction between the ‘cash’ and ‘futures’ markets is that the ‘cash’ market doesn’t have an expiry date. On the other hand, the ‘futures’ market has an expiry date, commonly referred to as a ‘rollover.’ A futures contract is essentially an agreement between the buyer and the seller on the price the buyer must pay at a future date.

Index investing

Now let’s take a look at index investing, which is a more passive investment strategy. The goal of index investing is to passively imitate the performance of a certain index. If you’re looking to reduce your exposure to risk while increasing your chances of a steady return, then index investing might be a good option for you. Active investment is avoided because, according to mainstream economics, it is impossible to “beat the market” once transaction costs and taxes are factored in.

Given the low-key nature of index investing, expense ratios (ERs) for index funds are typically lower than those for actively managed funds. Offerings may keep their prices low since they require no professional assistance in the form of a portfolio manager to keep up with the market. Since index funds often make fewer trades than active funds, they also tend to be more tax efficient.

In addition, index investing could potentially be an excellent way to diversify your portfolio and lower your overall exposure to risk. The assets in an index fund are spread out across many holdings rather than concentrated in a few stocks or bonds. This helps reduce the odds of losing money on a single company’s or an industry’s investments while keeping the potential gains constant.

The S&P 500 is often used by index investors as a measurement of performance since it represents the overall health of the US economy. The Dow Jones Industrial Average (DJIA) and corporate bonds are two other commonly followed benchmarks for index funds.

Examples

In the stock market trading universe, there are literally thousands of indexes. But here we’ll list out some of the most common ones that you’ll come across:

The S&P 500

The S&P 500, one of the most well-known indexes, tracks the performance of the top 500 corporations in the United States, as defined by a committee at S&P Dow Jones Indices. It is a capitalization-weighted index.

The Dow Jones Industrial Average

The DJIA has a somewhat limited scope, tracking the performance of only 30 US corporations chosen by S&P Dow Jones Indices. The stocks in the DJIA originate from a variety of industries, ranging from healthcare to technology, but they are all blue-chip equities. Unlike the S&P 500, this index is price-weighted.

The Nasdaq 100 

The Nasdaq 100 index analyzes the performance of 100 of the Nasdaq stock exchange’s largest and most actively traded stocks. Companies on the Nasdaq can also come from a variety of industries, although they tend to lean toward technology and do not contain any members of the financial sector. It is also based on market capitalization.

NASDAQ Composite 

The NYSE Composite Index is a broad index that follows the performance of all New York Stock Exchange equities (NYSE). It is also weighed by market capitalization.

Russell 2000 Index

Unlike other stock market indices, which focus on the largest companies in a specific sector, the Russell 2000 tracks the performance of 2,000 of the smallest publicly traded domestic companies. It is a market cap-weighted index.

Total Market Index Wilshire 5000

The Wilshire 5000 Total Market index analyzes the performance of the whole stock market in the US. With this index, again, market capitalization is used to weigh it.

Note: there are also different types of market indexes, such as Environmental, Social and Governance (ESG), currency indexes, global indexes, national indexes, growth indexes, value indexes and sector indexes. But more on those another time. 

Bottom line

Indexes are a great way for you to look at a large market sector without having to observe each particular asset in the index. For example, it wouldn’t make sense for you to look at hundreds of different stocks’ prices to figure out how tech companies’ fortunes fluctuate. But an index for the whole sector, like the NASDAQ-100 Technology Sector Index, can show you the average trend for the sector as a whole. And that is why we stan a good market index.

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