Index Investing is an Easy Way to Guarantee Average Performance

Index investing is the easiest way to put your money into the market. But is it the safest?

When you buy index funds, you can have your money follow the "averages" (i.e. exchanges or markets where financial instruments are traded).

The term "exchange" comes from the fact that a market is where shares are exchanged for currency, and vise verse.

Stock exchanges exist across the globe; London, the Euronext, Frankfurt, Tokyo, and Madrid are a few examples.

The primary markets in the United States are the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and the Nasdaq Stock Market (NASD).

There are also several smaller regional exchanges, such as the Chicago Stock Exchange.

Investing in Stock Indexes

Before we get started, you should know something. You cannot invest directly in an index; an index is actually just a math problem - a calculated average of all its pieces.

Investments (such as mutual funds and ETFs) try to copy the averages by buying all the different components of the index.

If the funds replicate the pieces of the index, then the price movement of the funds should mimic the averages on a long-term basis.

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Advantages of Index Investing

  • Low transaction costs
  • Exposure to an entire index worth of investment instruments
  • "Guaranteed" average performance

Drawbacks of Index Investing

  • Fees related to managing the index fund lower your return
  • Exposure to a single asset class (not diversified)
  • "Guaranteed" average performance

The Two Types of Indexes

Since an index is made up of many different parts, how do fund companies combine them all? And how do they handle all the changes that occur every day?

The two most common ways of pulling indexes together are price and value weighting.

A price-weighted index is proportional to the sum of all the prices for components in that index.

For example, the Dow Jones Industrial Average (DJIA) is a price weighted index of 30 stocks. This means that daily price movement of the DJIA is directly related to the sum of all 30 stocks’ price movement for a given day.

The "average" is calculated using the cumulative price of all the stocks in the index, divided by an arbitrary index divisor (the arbitrary index divisor is arbitrary because the people who manage the index decide what number to use).

Safe Investing Tip Safe Investing Tip:

Stocks with high prices influence the performance of a price weighted index more than stocks with low prices.

Assume you've started index investing, using a price weighted index of two stocks; one trading at 10 and one at 100.

The higher priced stock's performance will dictate the price action of the average. The high priced stock will move the index 10 times more than the lower priced stock.

A value-weighted index is proportional to the total "capital value" of all the index’s components.

For example, the Standard and Poors 500 index (S&P500) is a value-weighted index of 500 stocks.

The daily performance (price movement) of the S&P500 is the change in capital value of the 500 stocks that make up the index.

It is the total value of all the stocks in the index, divided by an arbitrary index divisor (again, the arbitrary index divisor is arbitrary because the people who manage the index decide what number to use).

The advantage of this type of index is that adjustments for things like stock splits, dividends, and other actions by the company are automatically factored into the price.

The disadvantage, similar to a price-weighted average, is that securities with the highest capital value (such as a mega-cap stock) have the most influence over the performance of the index.

Stock Index Segmentation

With the invention of the ETF, there seems to be an index or average for almost everything. I've even heard about averages of averages!

Some indexes are based on an exchange, such as the NYSE or NASD. Others are based on asset classes, proprietary equations, products, industry, or market capitalization.

Here are some examples of the various stock indexes used for index investing:

Sector Basis

  • Defensive
  • Growth
  • Health Care
  • Utilities

Market/Index Basis

  • S&P400/500/600
  • AMEX
  • Russell 2000
  • AMEX Japan
  • PHLX Gold/Silver
  • Value Line
  • NASDAQ 100
  • NYSE
  • NIKKEI 225
  • Reuters/Jefferies-CRB (Global Commodities) Index

Market Capitalization (Values subject to change)

  • Nano Cap (Less than $50 million)
  • Micro Cap ($50 million to $300 million)
  • Small Cap ($300 million to $2 billion
  • Mid-Cap ($2 billion to $10 billion)
  • Large Cap ($10 billion to $200 billion)
  • Mega Cap (Greater than $200 billion)