Stock Indices
By Adrian Pedroza and Wittmann Goh
Adapted by Nicolette Lamanna
What is an index?
An index is simply a ”method to track the performance of some group of assets in a standardized way.”
In other words, an index measures how well a particular group of stocks is doing in the stock market.
Indices are generally constructed as a basket of securities (group of investments) that mirror/replicate a particular area of the market (e.g. Healthcare, Technology, Energy, etc.).
Source: Investopedia
What is an index fund?
Investors do not and cannot directly buy an index. Rather, they invest in “index funds,” which are made up of securities like those in the target index.
Index funds attempt to mirror the returns (gains & losses) of the target index.
In short, by having similar investments, index funds solve the problem of being unable to buy an index while still giving you that index’s returns.
What types of indices are there?
There are many different stocks. We’ve simplified them based on two factors:
Weight methodology: How much does each stock in its basket contribute to the overall value, and how is this determined? Common examples we’ll be breaking down are:
Equal Weighting
Price Weighting
Market-Capitalization Weighting
Coverage: What criteria does the index use to select the stocks that it covers and tracks (invests in)? Examples include:
Country/Regional/Global Coverage
Sector-based Coverage
Examples of Stock Indices
Standard & Poor’s 500 Index (S&P 500)
Contains 500 of the top US firms. “Market capitalization” is largest factor for deciding which stocks to include in index.
Nasdaq Composite Index (Nasdaq)
Similar to the S&P 500 in that market capitalization is a big determining factor, but the Nasdaq focuses more heavily on Technology stocks.
Dow Jones Industrial Average (Dow Jones)
A price-weighted index and includes the stocks of the 30 largest and most influential companies in the US.
DAX 30
Consists of the 30 largest companies listed on the Frankfurt Stock Exchange in Germany, based on market capitalization and liquidity.
Nikkei 225
A price-weighted index that tracks the top 225 Japanese companies based on their market capitalization, and is seen as an indicator of Japan’s equity market.
Source: TradingView
What is Market-Capitalization?
Market capitalization is one method of estimating the value of a company. It is calculated as:
Example: Tesla Inc (TSLA)
Tesla currently has ~931.81M outstanding shares as of October 2020. The most recent price per share of Tesla was $415.09. So, to calculate the current market capitalization of Tesla:
M = $415.09 • 931.81 million shares
≈ $386.784 billion market cap
What is a price-weighted index?
Stocks with the highest prices make up the largest percentage of the index
Higher stock price = more weight
Lower stock price = less weight
What is an equal-weighted index?
Every stock in the index is invested in equally
The same amount of $$$ gets invested in each stock
Example: An index with 100 companies’ stocks would have 1/100th of its value invested in each one
What is a capitalization-weighted index?
Stocks with a higher market capitalization make up more of the index
This is one of many ways to give “bigger” companies more weight/influence on the overall index
Which index funds should I buy?
Index funds are usually a sound investment for most investors. The number of available options may feel overwhelming, but here are a few words of general advice:
Go for index funds managed by large brokerages (like Fidelity and Charles Schwab) and investment managers (like Vanguard). You’ll likely pay less in fees with these companies due to competition-fueled price cuts.
Do stock prices matter?
Many individuals are heavily influenced by stock prices, which can often be misleading.
For instance, take two companies, Apple and Chipotle. Apple currently has a market capitalization of $1.933 trillion. Chipotle, on the other hand, has a market capitalization of $35.09 billion.
Apple’s stock price: $113.02
Chipotle’s stock price: $1,254.80
Chipotle’s stock price is over 10x higher than Apple’s, even though Apple’s market capitalization is 50x higher than Chipotle’s.
While stock prices can sometimes be a helpful tool, it’s important to look at the whole picture.
Risk
Different indices fall to different risk categories
Investing in indices requires that an investor consider his/her tolerance for risk and financial goals.
Even though indices by and large are lower-risk investments, some (like the Russell Small Cap Completeness Index) can still have high risk.
Risk isn’t necessarily bad, since more risk usually means the potential for higher returns, but it’s important to understand how much risk you are and should be taking on
Different people will want to take on different amounts of risk
Markets and stock prices fluctuate over time. This means it’s impossible to predict the future. Investing in anything means taking on some amount of risk.
The amount of risk one investor can take generally depends on his/her investing timeline (ie. how long until you’ll need the money), as well as personal preference.
A good rule of thumb...
A lot of conventional wisdom says to invest more aggressively (with higher risk) when you’re young, since time will help average out the ups and downs over several decades.
As you get older and closer to using your money to buy a house, car, retire, etc., you’ll want to shift over to lower-risk investments to avoid a potential big loss right before you need your money.