Stock Market Index – Part I: Indices, Defined

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The Dow Jones Industrial Average topped 20,000 for the first time on January 25, 2017, but you probably already knew that as every media outlet went crazy reporting the “news”. But when a popular index like the Dow is on a tear, up or down, what does it really mean to you and your investments?

That’s the real question we need to ask ourselves.

In this multi-part series, we’re going to cover some of the ins and outs of market indices and the index funds that track them.

What Is an Index?

Let’s set the stage with some definitions.

An index tracks the returns generated by a basket of securities that a sponsor has put together to represent (“proxy”) a particular sector of the market.

Some of the familiar names among today’s index providers include the S&P Dow Jones, MSCI, FTSE Russell and Wilshire. It’s perhaps interesting to note that some of the current index providers started out as separate entities – such as the S&P and the Dow, and FTSE and Russell – only to consolidate over time. In any case, here are some of the world’s most familiar indices (with “familiar” defined by where you’re at):

  • S&P 500, Nasdaq Composite, and Dow (U.S.)
  • S&P/TSX Composite Index (Canada)
  • FTSE 100 (U.K.)
  • MSCI EAFE (Europe, Australasia and the Far East)
  • Nikkei and TOPIX (Japan/Tokyo)
  • CSI 300 (China)
  • HSI (Hong Kong)
  • KOSPI (Korea)
  • ASX 200 (Australia)

…and so on

Why Do We Have Indices?

Early on, indices were designed to offer a rough idea of how a market segment and its underlying economy were faring. They also helped investors compare their own investment performance to that market. So, for example, if you had invested in a handful of U.S. stocks, how did your particular picks perform compared to an index meant to track the average returns of U.S. stocks? Had you “beat the market”?

Then, in 1976, Vanguard founder John Bogle launched the first publicly available mutual fund specifically designed to simply copy-cat an index. The thought was, instead of spending time, money and energy trying to outperform a market’s average, why not just earn the returns that market has to offer (reduced by relatively modest fund expenses)? The now familiar Vanguard 500 Index Fund was born … along with index fund investing in general.

There are some practical challenges that prevent an index from perfectly replicating the market it’s meant to represent. We’ll discuss these in future segments. But for now, the point is that indices have served investors across the decades for two primary purposes:

  1. Benchmarking: A well-built index should provide an approximate benchmark against which to compare your own investment performance … if you ensure it’s a relatively fair, apples-to-apples comparison, and if you remain aware of some of the ways the comparison still may not be perfectly appropriate.
  2. Investing: Index funds that replicate indices allow you to indirectly invest in the same holdings that an index contains, with the intent of earning what the index earns, net of fees.

Indices Are NOT Predictive

There is also at least one way indices should NOT be used, even though they often are:

Index milestones (such as “Dow 20,000”) do NOT foretell whether it’s a good or bad time to buy, hold or sell your own investments.

Indices don’t tell us whether the markets they are tracking or the components they are using to do so are over- or underpriced, or otherwise ripe for buying or selling. Attempting to use current index values as a way to time your entry into or exit from a market does not, and should not replace understanding how to best reflect your unique investment goals and risk tolerances in an evidence-based investment strategy.

In fact, market-timing of any sort is expected to detract from your ability to build wealth as a long-term investor, which calls for two key disciplines:

  1. Building a cost-effective, globally diversified portfolio that exposes you to the expected returns you’d like to receive while minimizing the risks involved
  2. Sticking with that portfolio over the long run, regardless of arbitrary milestones that an index or other market measures may achieve along the way

As one commentator observed the day after the Dow first broke 20,000: “Sensationalism of events like these [Dow 20,000] has the ability to trigger our animal spirits or our worst fears if we don’t have a long-term investment plan to keep them in check.”

So first and foremost, have you got those personalized plans in place? Have you constructed a sensible investment portfolio you can adhere to over time to reflect your plans? If not, you may want to make that a top priority. In the next Financial TIPs, we’ll explore some of the mechanics that go into indexing, to help put them into the context of your greater investment management strategy.

 

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