Index Investing 101

It’s important to you and your investments that you understand the basics of how indexes and index funds work.

What Is an Index Anyway?

In the words of Lewis Carroll, let’s “begin at the beginning” with a simple definition.

An index keeps track of returns generated by a basket of securities, and it’s put together by an indexer to “proxy” or represent a specific corner of the market.

Some of today’s most popular index providers started off as separate entities altogether – for example, the S&P and the Dow, and FTSE and Russell – but eventually consolidated over time. That being said, here’s a list of some of the most familiar indexes in the world today:

• S&P 500, Nasdaq Composite, and Dow Jones Industrial Average (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)

Why Do We Even Have Indexes?

Very early in the game, indexes were created to offer a rough idea of how a particular market segment was doing, along with the market as a whole. They were also good for investors, letting them compare their investment performance to the market.

For instance, if you put your money in a handful of U.S. stocks, an index would allow you to know how your picks performed compared with the average returns of U.S. stocks overall.

In 1976, John Bogle – the founder of Vanguard – launched the first publicly available mutual fund designed specifically to track an index (there were other, earlier versions of index funds, but they weren’t publicly available). Bogle figured, why spend the time, money, and energy attempting to outperform a market’s average when you can just earn the returns that the market can provide (with modest fund expense reductions)? That’s how the Vanguard 500 index came into the world, along with the new enterprise of index fund investing.

While a few things can get in the way of an index mirroring its representative market perfectly (we’ll talk about that later), indexes are useful to investors for two basic reasons:

1. Benchmarking: A properly built index will give you an approximate benchmark to compare your investment performance against. But it has to be a more or less fair face-value comparison, and you need to remember that the comparison might not be exact.

2. Investing: An index fund that replicates indexes will let you invest in the same holding an index contains, in an indirect way – all so you can earn what the index earns, net of fees.

Indexes Are NOT Predictive

Indexes most definitely should NOT be used as predictors, but that doesn’t seem to stop people from trying:

Index milestones (such as “Dow 40,000”) CANNOT foresee when it’s a good or bad time to buy, hold, or sell your own investments.

What indexes won’t do is tell us if the markets they’re tracking (or the components they’re using to do the tracking) are overpriced, underpriced, or ready for buying or selling. Using current index values to time your entrance or exit from the market is market timing, and that doesn’t work. Your investments should be informed by your personal investment goals and tolerance to risk, not someone’s hunch based on index values.

Indexes Are NOT Perfect Mirrors

As I mentioned before, indexes definitely have their uses. They’re a terrific tool for getting a rough feel for the mood of a market. If your plan is to capture the market in question, you can compare and roughly determine how your plan is working out.

This may help explain why everyone seems to be forever watching, analyzing, and talking about the most popular indexes and their every move. But you may still have questions about what they are and how they really work. For example, what do the Dow Jones Industrial Average (the Dow) points even measure?

An index’s total points represent a relative value for the market it is tracking, calculated by continually assessing that market’s “average” performance.

That’s a little technical, so let’s break it down. Any time you check in on an index, it’s like dangling your toes in the waves to see how the entire ocean’s doing. You may have good reasons to do a toe test every now and then, but keep in mind this is just an approximation. It can be easily misread.

So, with this bit of caution in your ears, I’d like to make a few points of my own on index points.

Indexes Are Often Arbitrary

How do popular indexes become popular in the first place?

In a free market system, competitive forces have the freedom to introduce new and different structures to see what works and what doesn’t. It’s like how the markets “decided” that the iPhone would eventually win over the Blackberry – the people made their choice. That’s basically how one index gets accepted over another. Sometimes, the best index wins out, sometimes not.

Measurements Will Vary

Indexes can be structured very differently from one another. That’s why the Dow and the S&P 500, which are both used to gauge the very same U.S. stock market, act so differently. They’re built differently.

The Dow determines its average by adding the price-weighted prices of the thirty securities it’s tracking and then dividing the total by a propriety “Dow divisor.” This is a throwback to when “computer” was a job title, not a thing.

The S&P 500 is different. It also adds up the (approximately) 500 securities it’s tracking but weighs it by market cap and divides it by its own divisor. This market cap weighting is crucial as it allows you to capture the relative importance of the component securities.

So, with these mysterious divisors, not to mention terms like “price-weighted” and “market cap” and more we don’t have the time to get into, you’re probably still left wondering what index points are.

Think of each index point as a degree on a thermometer. Even if you can’t explain exactly how a thermometer works, you can tell the difference between “hot” and “cold,” and thirty-two degrees Fahrenheit is a world apart from thirty-two degrees Celsius.

It’s the same way with indexes. When you try to compare an S&P 500 point with a Dow point, it doesn’t make any sense. Not to mention that neither index adjusts for inflation.

So yes, even though it’s true that index values can give you an idea of how “hot” or “cold” a market is at the moment, they can’t tell you when a market is too hot or too cold, much less help you predict when to buy or sell in or out of them with any accuracy. There’s simply no point for comparison, which brings us to our next point…

All Models Are Approximate

There’s a huge difference between a hard science like thermodynamics and the way market measures like indexes work. When you take a look at a thermometer, a degree is simply a degree. With market indexes, on the other hand, points are based on an approximate calculation of how a market is actually performing. That is, it’s based on a model.

There’s no way around it; a model is just a copy of what’s really going on, and some copies are more accurate than others. Nobel Laureate Eugene Fama has this to say about them: “No model is ever strictly true. The real criterion should be: Do I know more about markets when I’m finished than I did when I started?”

What’s Your Takeaway?

If we keep Fama’s account of a model in mind, indexes are useful proxies to aid us in getting a better idea of what’s really going on within a particular segment of our capital markets. But if you misinterpret what they’re saying, they can do big damage to your overall investment experience.

Just keep this in mind: The popular appeal of an index is very often the result of an arbitrary consensus that could be a reflection of either rational reasoning, behavioral bias, or both. The structures will vary, and the accuracy will be approximate at best. Yet even a familiar index can relay some unexpected structural insights.