What is an Index and Why Should I Care?

What is an Index and Why Should I Care?

Most investors have heard the term ?index?, but what does it really mean? An index is an assortment of investments designed to perform in a way desired by the entity that created the particular idea. For example, when people think of the stock market, they are usually picturing the Dow Jones Industrial Average or the Standard and Poor's 500. The difference between these two is that the Dow is made up of 30 companies that the Dow Jones organization thinks is representative of the U.S. economy. The Dow is price weighted, meaning that when you invest money in the index, more money will be invested in United Technologies than any of the other 30 stocks since UTX has the highest current price.

Alternatively, the S&P 500 is made up of the 500 largest U.S. companies and is market capitalization weighted. This means that when you invest in the S&P index, you are buying a piece of 500 different stocks, with the most money going to General Electric and Exxon since those are the two largest U.S. companies. Although these are the two most common indices, there are hundreds of others that track a multitude of ideas such as small companies, medium companies, sectors, industries, bonds, and foreign investments. We?ll discuss these in future editions, but today, we?ll stick to more broad indices.

The limitation of the Dow and S&P 500 is that they only represent large companies. Often, investors wish to have exposure to a wide range of holdings in order to diversify their portfolio, as an example, the Wilshire 5000 is designed to track the performance of practically all U.S. stocks and is considered to be the broadest of all. A more recent development is to use a standard index such as the S&P 500, but give equal weight to each of the 500 stocks. For instance, the Rydex S&P Equal Weight exchange traded fund allows smaller companies to have more performance impact while avoiding high concentration in the largest stocks. The fund rebalances every quarter back to the original weighting, creating a ?buy low ? sell high? effect. Equal weighted index funds are gaining popularity since they automatically correct several potential problems four times per year. Finally, another new type of broad index uses company fundamentals to determine the weighting. The FTSE RAFI indexing style recently won an award for the most innovative benchmark for 2005.

With such a wide variety of ways to participate in U.S. equities, it pays to know what you really have ? because when it comes to investing, ignorance is not bliss.