A stock market index is an investing tool that tracks the performance of a group of stocks or assets, giving investors a quicker, more straightforward method of gauging the market or a market sector’s overall health.
Although many Americans believe stock market indexes are inventions of the modern information age, they’ve been around for over 100 years.
In 1884, Wall Street Journal co-founder Charles Dow came up with his Dow Jones Transportation Average (DJTA.) Initially, the DJTA consisted of nine railroads, eleven transportation companies, and two non-railroad companies. A decade later, Dow and his colleagues came up with the better-known Dow Jones Industrial Index (DJIA).
Early indices were somewhat limited in their utility. Their lack of usefulness was because they tended to be highly concentrated and often used their own non-standardized calculation methods.
Since its development in 1957, the S&P 500 index has given investors a more diversified market-cap-weighted stock selection and consistent calculations. Stock market historians tout the S&P as the first genuinely investor-friendly benchmark. To this day, the S&P remains an iconic index. Millions of investors use it as a benchmark against which they evaluate returns in their portfolios.
Since the S&P’ arrived on the scene, indexes have mapped out more asset classes. For example, bonds got their first index in 1973
There are currently around 5,000 indices in the United States to make market health evaluations simpler and more efficient. Rather than needing to track millions of individual stocks, investors follow their preferred indices, such as the Dow Jones Industrial Average (DJIA), NASDAQ, or Wilshire 5000.
Modern indexes use standardized methodologies to measure the price performance of a “basket” of securities intending to replicate a specific market area. As mentioned, you could have a broad-based index looking at the entire market, such as the DJIA. Or, niche indices can track a particular market segment (small-cap stocks, for example) or industry. Some indexes measure other data types, such as inflation, interest rates, or industrial output.
How do people invest in indexes?
Passive index investing has become increasingly popular with investors seeking to replicate index returns. Although you can’t invest money directly in an index, you can own various financial vehicles with specific underlying indexes. Banks, investment companies, or other regulated third parties create index-linked investment products. They are looking to mirror an underlying index’s performance as much as possible, minus fees.
Types of index-linked products
Fixed-indexed annuities (FIAs) are a popular retirement-oriented product offering guaranteed interest rates and rates linked to a specific market index. Although some fixed indexed annuities use broad, well-known indexes such as the S&P 500, a few link to market segments. Some FIAs may let you pick more than one index. The main idea here is that a FIA may allow you to participate in market gains while providing downside protection.
However, you should be aware that FIAs are not as straightforward as they may appear. Methods used by annuity companies to calculate the index gain are often challenging to understand.
Indexed annuities can be a confusing product for even the savviest investors, requiring a thorough knowledge of a specific annuity’s calculation methods. Such understanding is essential if you need to compare one indexed annuity contract to another. Anyone considering a FIA or any other type of investment, for that matter, is wise to partner with an expert before making decisions.
Index Exchange-traded funds (ETFs)
An increasingly popular product for individual investors is the exchange-traded fund. An ETF is, at its core, a basket of securities you sell on a stock exchange through a broker. ETFs may allow investors to leverage their dollars and potentially avoid or offset short-term capital gains taxes. In 2021, there were around 3,000 index ETF products tracking indexes such as the NASDAQ, S&P 500, and others.
An indexed universal life policy (IUL)
A type of permanent life insurance, IUL insurance has both a cash value account and a death benefit. An IUL’s cash value component may earn interest based on a market index selected by the issuing company.
While indexed universal life might provide more significant upside potential and tax-advantaged gains, it remains a complex, somewhat controversial product.
Some financial experts dislike IUL’s returns caps and the lack of guaranteed rates. There may also be issues in how these policies are marketed, with some agents providing unrealistic, misleading, or incomplete illustrations. How the policies are marketed can mean that although an IUL might look great on paper, potential purchasers must proceed cautiously.
Again, as with FIAs, the mechanics of an IUL policy are not always entirely fathomable. While they can be valuable tools for specific investors, this is another case where you will need another set of experienced eyes to help you evaluate your options.
Indexes can be helpful tools as investor benchmarks. While you can’t put money directly into an index, you can purchase various products incorporating an indexing strategy, including FIAs, IULs, ETFs, and other vehicles. Index investing is often complicated, and crediting methods may be confusing. For this reason, you should always engage a trustworthy, experienced advisor to guide you.
*This article is not intended to provide financial advice. It was written to educate, entertain and inform. Nothing in this article is promoting ANY financial product or service or may be construed as investment advice. Investors are urged to get advice from competent, experienced, licensed agents or advisors before making any mney decisions. (Don’t try this at home alone!)