You’ve probably heard the term “index” many times in reference to the stock market. But what are they? How are they determined? How do they affect me and how can I use them? For an in-depth understanding, go to school and get an MBA. For the Reader’s Digest version, read on for a quick rundown of the basics.
First, indexes are simply a way of measuring the movement up or down of a market or economy. For instance, the Consumer Price Index measures changes in the price level of goods and services in our economy. Stock market indexes, like the Dow Jones Industrial Average or the S&P 500, measure the investment returns of the market or a portion of the market.
The actual methods of doing this are not simple. A selected group of securities is chosen that is meant to be representative of the entire market or a specific portion of the market. Different indexes vary in the securities they track and how those securities are weighted when calculating the index. Weighting can be based on market capitalization, price, fundamental company features (value, cash flow, revenue) or may even weight all securities equally.
You cannot invest directly in an index. However, there are investment vehicles that track the performance of an index. Some mutual funds and exchange-traded funds (ETF) invest in some or all of the target funds in a given index. This style of fund management is known as passive management. As opposed to active fund management, which strives to beat the index returns, index funds may offer lower expenses and lower taxable distributions.
We can help with tax questions on your investments and be sure to read the fine print and consult your financial advisor when investing.