What Is A Stock Index And How To Use Them

You already know what a stock index is but you may not realize it. If you are familiar with the terms “S&P 500”, “DOW Jones Industrial Average” (or just “DOW”) or “NASDAQ” you already have it down. These are stock indexes. Didn’t know you were so smart…did you?

An index is just a basket of stocks that somebody (fancy) thinks means something. The people who own the index and license it out calculate the value of the stocks held in that basket and report the values. If that value rises, it means that the stocks in that basket increased in value as a whole. Investors often take that to mean that the overall health of the market is strong as well (if it’s a broadly based index like the S&P 500).

If the index drops it means the collective value of shares held within that basket declined as a whole. Again, investors could interpret that as a negative omen for the future of the general market.  Stock index funds try to replicate the performance of the stock index. They do this by purchasing the stocks held by the index.  That’s a story for another day.  For now, we’re only talking about the index itself.  Comprende?

Why People Care

People watch indexes for two reasons. First, the index can give you an idea as to how the overall market is moving at any given time. You’ll understand this better if you think about going to the doctor for a checkup.

If you go to a doctor, the first thing she’ll do is stick a thermometer in your mouth to get a general idea about your overall health. A stock market index is to the market as the thermometer is to your physical health. It gives the person reading the results an idea as to what’s going on “under the hood”.

The second reason why people track indexes is because they often gauge how well their own investments are performing when they compare their own performance to that of the index. For example, if the S&P 500 rises 10% this year and your portfolio only increases 2% you might be upset thinking you underperformed. As a result this might cause you to change your asset allocation and take on more risk. This is the main problem but we’ll get back to that in a minute.

All Indexes Are Not The Same

Indexes can either be very broad or very narrow. Some stock indexes represent the entire market while others only represent large, medium or small companies. Others only represent one sector of the economy like energy or health services. Still others represent regions like Europe or countries like China. The sky’s the limit when it comes to shapes and sizes of market indexes but they are certainly not interchangeable.

The most popular stock index is the S&P 500. This index is made up of 500 of the largest companies in the United States. These companies come from all different sectors and industries. This is a pretty reliable measurement of the overall market because the companies within this index make up about 70 percent of all the publicly traded stocks. Let’s get to the main point.

The Problem With Stock Market Indexes

There are a number of problems with indexes but I hinted at the biggest one above. People often gauge their portfolio performance to an index when they should not. Let’s look at the example above to illustrate how dangerous this is.

Assume you don’t like taking huge risks. Let’s say you feel more comfortable with a balanced portfolio because your objective is to grow your money safely. As you know, a balanced portfolio is made of funds that hold stocks and bonds.

Assume that you make your investments and after the first year, you become disappointed. Your portfolio increased 2% while the S&P 500 index climbed 10% as in the hypothetical above. You find this intolerable so you dump your balanced portfolio and go 100% equity. Here’s the problem with that.

You just took on a lot more risk by making this change. Your portfolio had stocks and bonds for a reason – to reduce risk. The S&P 500 only has stocks in it and that means more risk. In a strong market of course that index is going to outperform your balanced account. But what is it going to do in a down year? Most people don’t think about that.

When you make a move like this you change your investment objectives. In this example, your objective was to grow your money safely. But now your objective is to track with the S&P 500. There is nothing wrong with this new objective if you are comfortable with the risk. But most people don’t think about the risk when they change the portfolio allocation. They just think about the potential rewards. Awkward.

The same problem happens when you compare a broadly based portfolio to a narrow index. Let’s say your account went up by 10% in the example above. But you are unhappy because a China index increased 30%. Of course it’s a mistake to compare a broadly based account to a very narrowly based index like China but people do it all the time.

There is nothing wrong with following market indexes. But don’t make investment decisions solely based on how you do compared to that index. Instead, think about your overall financial objectives and make sure you are tracking to achieve those. That’s far more important.

Please tell me, do you use market index performance to make investment decisions? How? Has it helped or hurt you? Help me understand you better.