In Investing, What Is An Index?

An Index is a Measuring Device for Investments

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An index is like a ruler. You use it to measure price movements. BartSadowski/E+/GettyImages

An index is like a ruler. It is a way of measuring the performance, or price movement, of just about anything.

You'll see the plural of an index as both "indices" and "indexes".

In the financial world, indexes are created to track items such as publicly traded stocks, bonds, and consumer prices for common goods and services.

Below Is a List Of Common Indices That You Hear about in the News

  • The S&P 500 index tracks the performance of stocks of 500 of the largest companies in the United States.
     
  • The Russell 2000 index tracks the performance of smaller, publicly traded companies.
  • The MSCI EAFE index (EAFE stands for Europe, Asia, Far East) measures the performance of stocks in developed countries outside of the United States.
  • The Dow Jones Index tracks the performance of only 30 companies. These 30 companies are selected from different industries to represent the largest and most widely held publicly traded companies in the Unites States.
  • The Consumer Price Index was designed to track inflation.

There are  hundreds of indices that track the price of just about anything you can think. Bloomberg keeps a list of stock indexes by country. At one point I counted just the indexes listed in the USA and there were 198.

Here Is an Example Of How an Index Works

  • Suppose we created an index to track the price of a gallon of milk.
  • When we start tracking let's say milk costs $2.00 a gallon.
  • The starting index value is 1.
  • When milk goes to $2.50, our index goes to 1.25, which reflects a 25% increase in the price of milk.
  • If milk the goes to $2.25, the index goes to 1.15. The .10 change reflects a 10% decrease in the price of milk.

If you were a milk dealer you might find a milk index useful. Instead of going to the store each day to write down the prices of each competitor's milk and averaging them together, the index would provide that data for you.

Stock market indexes are used by traders, economists, and academics, but each uses the information in a different way.

For the average person, the day to day change in the stock market should have no relevance to their life, so why pay attention? I don't know. Maybe people pay attention because the media focuses so much attention on the day-to-day change in indices like the S&P 500 or Dow Jones.

Most people should develop a long-term investment plan that uses index funds, which own all the stocks listed in an index, and they should leave their investments alone for years and not obsessively watch the market.

Next: What Is An Index Fund And Why Would I Use One?