Why is an Index Important in Investing?

Everywhere you turn, you hear or read personal finance experts advocating the use of index funds in your portfolio. Employees often call our Financial Helpline asking if their 401(k) funds are index funds or wondering what exactly an index fund is and how to pick the right one for them. They also ask how they can know if their mutual fund is performing well. The key to both is understanding indexes.

An index is a statistic

An index is a statistic measure of change in the prices of major groups of stocks or bonds which represent an area of the overall market. In investing, indexes are used as a guide to constructing portfolios, and to set a starting point (benchmark) and measure portfolio performance over time. Indexes are usually capitalization-weighted, meaning that the largest companies have the most influence on the index. Common indexes like this include:

  • The S&P 500®, which includes 500 large companies in a market capitalization weighting, and is widely viewed as a benchmark for the U.S. stock market. If you’ve got a “large company growth fund” in your retirement account, it’s likely its performance will be compared to the S&P 500. You can track the index by entering symbol SPX.
  • The NASDAQ Composite Index includes all the stocks which trade on the NASDAQ market. It includes a lot of technology companies, but isn’t limited to them. You can track this by entering symbol IXIC.
  • The Russell 2000 Index includes 2,000 small companies in the U.S. You can track this by entering symbol RUT. If you’ve got a “small company” or “small cap” fund in your retirement account, it’s likely that its performance will be compared to the Russell 2000.
  • The Bloomberg Barclays U.S. Aggregate Bond Index tracks a range of types of fixed income securities to represent the types of bonds in the bond market. If you have a “total U.S. corporate bond” fund in your retirement account, it is likely its performance will be compared to the Bloomberg Barclay’s U.S. Aggregate Bond Index. Bloomberg Barclays has many common bond indexes and you can find and track yours here.

Another well-known index that is frequently reported as an indicator of the total U.S. economy, the Dow Jones Industrial Average, is a measure of 30 U.S. blue chip stocks from all industries except transportation and utilities. It is a price-weighted average, which means that the most expensive stocks influence the index the most. You can track this by entering symbol DJIA.

An index fund mimics the index

An index fund is a type of mutual fund with a portfolio designed either to match directly or track the performance of an index. For example, an S&P 500 index fund would hold stocks of the companies in the S&P 500 index in direct proportion to how they are represented in the index. When you choose an index fund, you’re choosing a passive method of managing your investments. You won’t outperform the index, but should closely track the performance of the index, with slight underperformance due to trading costs and fees. Index funds are a great way to minimize the fees in your retirement plan or other investment portfolio, which can really add up over a long period of time. Not all index funds are created equally, however, so make sure you read the fund fact sheet and prospectus before you invest. Not sure about how to choose the right funds for you in your retirement account? Start here with an easy to read post from fellow planner Kelley Long on how investing is like choosing a pizza.

An index gives you a way to compare how you’re doing

Comparing your mutual fund to an index that contains similar stocks or bonds is an excellent way to measure how your fund is doing over time. A fund will generally disclose its benchmark, the index against which the fund management measures its performance. For a passive index fund strategy, the comparison is simple. An actively managed fund, which is designed to try to beat an index (although most don’t), may have a composite benchmark (made up of several indexes in pre-set proportions).

The upshot: do a review of your retirement accounts and other investments. Do you own index funds, and if so, what indexes do they track? Do you have a diversified portfolio of funds which track different indexes? Do you have actively managed funds, and if so, what indexes are they measured against? How did they do? If you’re not sure about where to start, call your Financial Helpline or call your financial coach if you have one.

Do you have a question you’d like answered on the blog? Please email me at [email protected]. You can follow me on the blog by signing up here and on Twitter @cynthiameyer_FF.

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