The S&P 500, The Nasdaq Composite, the Dow Jones and the ASX 200 are all examples of Stock Indexes. But what exactly is a stock index?
Don’t know what a stock, or what the stock market is? Check out What is the Stock Market?
To answer that lets first define what an index is.
What is an index?
An index is like a ruler; it is a way of measuring the performance, or price movement, of just about anything.
One index you may have heard of is the consumer price index or CPI, which measures inflation. The consumer price index measures the change in the price of a basket of goods and services. Say you had a shopping list that contained 10 items. The total cost for those 10 items equals $100. We will give the index a value of 100. Next year you buy those exact same 10 items but the total cost is $110. The index will now have a value of 110. We can calculate the percentage change over that year with the following equation.
In our example, we would get
Where:
The current index value = 110
The previous index value = 100
Now that we have defined what an index is we can find out what a stock index is.
What is a Stock Index?
A stock index is like the consumer price index but instead of measuring the prices of a basket of goods and services, it measures the prices of a group of stocks. Stock indexes are used to measure the performance of a stock market. When someone says “the US stock market was up yesterday” they are usually referring to the S&P 500. The S&P 500 is made up of the 500 largest stocks in the US. If someone says “the Australian stock market is down” they will usually be referring to the ASX 200 or the All Ordinaries. The ASX 200 is made up of the 200 largest stocks on the Australian Stock Exchange.
Some other stock indexes include:
- The Nikkei 225 for Japan
- The FTSE 100 for the UK
- The Hang Seng for Hong Kong
- And the DAX for Germany
Types of Indexes
There are three main types of stock indexes.
- Price-weighted
- Value-weighted
- Unweighted
Price-weighted
In a price-weighted index the greater the price of a stock the more weighting it will receive. Say you have an index made up of 2 stocks. One is priced at $100 the other is priced at $20. The change in price for the stock priced at $100 will have more of an impact on the index than the stock priced at $20.
Value-weighted
In a value-weighted index the greater the market cap of a stock the more weighting it will receive. A stock worth $10 billion has a greater effect on an index than a stock worth $1 billion.
Unweighted
In an unweighted index, all stocks are given the same weighting. All stocks in the index will affect the index equally.
How to Invest in a Stock Index
There are two main ways to invest in a stock index, they are:
- Index mutual funds
- Index ETFs
An index mutual fund is a pool of money that a professional will use to invest in an Index. An example of an index mutual fund is the Vanguard Index Australian Shares Fund which tracks the ASX 300 Index.
Index mutual funds will usually have an investment minimum. For example, the Vanguard Index Australian Shares Fund requires a minimum initial investment of $3,000.
Index mutual funds can only be bought and sold at the end of the day.
ETFs or Exchange Traded Funds are funds that can be bought and sold on a stock exchange like stocks.
Investing in index funds is a great way to get started investing if you dont know how to pick individual stocks.
Both index mutual funds and index ETFs are low-cost ways to invest in stock indexes.
Over the long term (10 years plus) you likely won’t see much difference in performance between an index mutual fund and an index ETF tracking the same index.
Investing in either an index mutual fund or an index ETF is considered “passive investing”.
Why Invest in an Index Fund?
Nobel Prize laureate Harry Markowitz said, “Diversification is the only free lunch” when it comes to investing. Investing in index funds is popular because it allows you to invest in hundreds of stocks at the same time.
Just take a look at the above chart which tracks the S&P 500. It has gone from around 85 in 1971 to 3898 in 2021. That is an increase of 4,485%. $1000 invested in 1971 would now be worth $44,840.
Another reason people invest in index funds is that they can’t or they don’t want to spend time trying to pick ‘winning’ stocks. Instead, they just buy them all or a large number of them. By investing in an index fund you are saying that you believe that businesses, in general, are going to continue to grow and produce profits over the long term. Just listen to what Mr Buffett has to say about index funds.
“The very nature of index funds is that you are saying I think America’s business is going to do reasonably well over a long period of time, but I don’t know enough to pick the winners and I dont know enough to pick the winning times.”
Mr Buffett also once said, “In my view, for most people, the best thing to do is owning the S&P 500 index fund”.
Summary
In summary:
- An index is a way of measuring the performance, or price movement, of just about anything.
- Stock indexes are used to measure the performance of a stock market.
- There are three main types of stock indexes. Price-weighted, value-weighted and unweighted
- There are two main ways to invest in a stock index, they are via Index mutual funds and index ETFs.
- Investing in an index fund allows you to invest in hundreds of stocks at the same time.
- You may choose to invest in an index fund if you don’t know how to or don’t want to try and pick winning stocks.
- Warren Buffett recommends most people simply invest in an index fund such as the S&P 500.
If you want to learn more about index funds check out the following resources.
Index: What Is It? (thebalance.com)
Index Fund Definition (investopedia.com)
What Is an Index Fund and Should You Invest in One? – NerdWallet
Index Fund vs. ETF: What’s the Difference? (investopedia.com)
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