A stock index is a statistical measure of the value of a group of stocks. It is designed to track performance and changes in the general market or specific sectors, such as technology or energy stocks. Stock indices compare the performance of investments and give investors an idea of how their investments are performing compared to other stocks.
What exactly is an index?
The index is a standardized technique for tracking the performance of a group of assets. Indices typically evaluate the performance of a set of investments designed to reflect a particular market segment.
Indexes can be broad-based, representing the entire market, such as the S&P 500 Index or the Dow Jones Industrial Average (DJIA), or more specialized, tracking a particular industry or area, such as the Russell 2000 Index, which specifically measures small-cap stocks.
Other financial or economic indicators, such as interest rates, inflation or production, are also measured by indices. Indices are often used as benchmarks to evaluate the success of a portfolio’s returns. Indexation, as an important investment approach, seeks to replicate such an index rather than passively outperform it.
An index is a type of indicator or unit of measurement. It is usually considered a statistical measure of change in the financial securities market. In the case of financial markets, stock and bond market indices are composed of a fictitious portfolio of securities representing a particular market or sector thereof. (You cannot invest directly in an index.) The S&P 500 Index and the Bloomberg U.S. Aggregate Bond Index are popular benchmarks for the U.S. stock and bond markets, respectively. Refers to an interest rate benchmark established by a third party in a mortgage context.
Each index related to the stock and bond markets has its own unique calculation method. In most cases, the relative change in the index is more significant than its actual numerical value. For example, if the FTSE 100 index is trading at 6670.40, investors know that it is approximately seven times its base level, which is 1000.3. However, to determine how the index has changed from the previous day, investors should consider the amount by which the index has declined, which is often stated as a percentage.
Investment indices are also often used as performance standards for mutual funds and exchange traded funds (ETFs). Many mutual funds, for example, compare their returns to the returns of the S&P 500 index to give investors an idea of how much more or less managers are making on their money than they would in an index fund.
The term “indexation” refers to a type of passive fund management. Rather than actively selecting stocks and market timing (selecting securities to invest in and planning when to buy and sell), the fund manager develops a portfolio reflecting the stocks of a specific index. It is assumed that the fund’s performance will match the profile of the index by mimicking it in the stock market as a whole or in a large part of it.
Examples of indices
The S&P 500 index is the best known and most commonly used benchmark for stock market valuation in the world. It represents 80% of all traded stocks in the United States. The Dow Jones Industrial Average, on the other hand, is well known. However, it measures the stock value of only 30 of the nation’s publicly traded corporations. The Nasdaq 100 index is another well-known index.
The Wilshire 5000 Total Market Index, MSCI EAFE Index and Bloomberg US Aggregate Bond Index are also examples.
Indexed annuities, like mutual funds, are linked to a commercial index. Rather than the fund sponsor trying to build an investment portfolio that closely resembles the index in question, these securities have a rate of return that follows a specific index, but there are usually limits to the returns they provide. For example, if an investor purchases an annuity indexed to the Dow Jones with a 10% cap, the rate of return will vary between 0 and 10%, depending on the annual changes in the index. Indexed annuities allow investors to buy securities that grow with broad market segments or with the entire market.
Adjustable rate mortgages have interest rates that vary over the term of the loan. The adjustable rate is calculated by multiplying the index by the yield. The London Interbank Offer Rate is a popular index on which mortgages are based. For example, if a 2% mortgage is indexed to LIBOR and LIBOR is 3%, the interest rate on the loan is 5%.