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Understanding Indexes Thumbnail

Understanding Indexes

The amount of information coming from our global financial system can make your head spin. Ever since the introduction of the first mechanical stock ticker in 1867, people have had the ability to track stock prices up to the minute. Today there are approximately 2,400 stocks that trade on the New York Stock Exchange, and even more traded on the Nasdaq. Globally as of 2019, it’s estimated there were 53,000 listed companies on 250 different exchanges and clearinghouses, with a total trading volume of nearly $88 trillion per year. Ever since the inception of mass communication, people have sought ways to simplify this information into something more digestible and useful.

The idea of a stock market index appeared in 1884 with the Dow Jones Transportation Index. The index consisted of 11 different stocks, mostly railroads, and was incorporated into Charles Dow’s “Customer’s Afternoon Letter” to provide a simple gauge of the market’s activity. The transportation index was supplanted 12 years later by the now famous Dow Jones Industrial Average (DJIA) consisting of 30 large industrial companies. Since the 1890s, dozens and then hundreds, of indexes have appeared—some more prominent than others— such as the S&P 500 in 1957, and the Russell 1000, 2000 and 3000. Just as the U.S. markets have their own prominent indexes, international markets have their own like the FTSE Euro 100, Nikkei 225, and the SSE Composite Index. These various indexes all serve the same purpose—to provide a benchmark to monitor the performance of “the stock market” and distill a vast amount of information into a single number.

What constitutes an index can be somewhat arbitrary and any organization with the resources and reputation to do so can publish their own index. Maintaining an index can be a sign of prestige for an organization and in today’s internet age, indexes can be found to track virtually all corners of the market and all types of securities. Beyond just stocks—bonds, commodities, and agricultural products have all been “indexized.” How each index is tracked and measured, the formula used, and its selection methodology can vary. The only limitation is imagination.

While indexes are very useful for economists, money managers, financial planners, and individuals—it’s important to understand their shortcomings. Indexes can be helpful to understand the market’s direction, identifying trends and correlations, and building narratives on what’s taking place in real-time. Where things get somewhat tricky however, is using a narrow index as a specific benchmark to your own success.

When evaluating indexes, remember that:

Indexes don’t have goals or time horizons: Unlike people with a life to live, retirement to plan for, and bills to pay—indexes aren’t beholden to any of these objectives. This allows them to “stay invested” through bull and bear markets without facing the consequences of risk, drawdown, or emotional decision making. The S&P 500 has been around for six decades without ever changing its objectives.

Indexes are un-investable: This seems counterintuitive due to the popularity of passive indexed ETFs and mutual funds, but ultimately no one can invest directly in an index. An index is just a roster of securities. Indexed ETFs and Mutual Funds seek to replicate their chosen index, but will typically lag because of transaction costs, timing, friction, and the costs inherent in administering an ETF or mutual fund.

Indexes can change their holdings without consequences, or taxes: Because an index is simply an aggregated list of securities, those underlying holdings can be changed at any time. The S&P 500 reconstitutes itself each quarter based on its methodology, and the Dow Jones Industrial Average has changed its components more than 57 times since its inception. Throughout these changes, indexes are never subject to the tax ramifications that an investor would face if they sought to make the same changes in their own portfolio.

Indexes don’t necessarily reflect diversification: We wouldn’t consider any specific index diversified enough to rely on for financial planning and risk management. As an example, even though the S&P 500 is constituted using the stock of five-hundred large U.S. companies, it ignores small and mid-size companies, international companies, and other types of securities like bonds, commodities, and alternative investment approaches. Depending on goals and risk tolerance, all these asset types have their role to play in a well-rounded portfolio.

Indexes can be very useful, but we need to understand their limitations. It’s easy to check whether an index is up or down, but indexes should serve as a gauge of market performance instead of as a specific benchmark by which we can measure our own success. When we ask ourselves, “How’s the market doing?” we should really be asking “which market?” and “compared to what?”

Investing involves risk. No investment strategy can guarantee positive results. Loss, including loss of principal, may occur. Material discussed is meant to provide general information and it is not to be construed as specific investment, tax or legal advice. Keep in mind that current and historical facts may not be indicative of future results. Diversification is an investment strategy that can help manage risk within a portfolio, but it does not guarantee profits or protect against loss in declining markets.

This content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. (C) Twenty Over Ten