‘Indexes’ are measuring sticks for markets – lists of stocks designed to reflect how a broader group of stocks is doing. You might have heard of some, like the S&P 500, the Dow Jones Industrial Average, and the NASDAQ Composite.
Indexing With Friends
Say you want to track average supermarket prices without having to follow every single item in the market.
You ask three friends to go to Krogers and make lists (indexes) of the thirty items they believe best represent prices in that market. They each like different foods, so their lists will be different.
Your first friend comes back with a selection of 25 different beers, plus a few different brands of chips and frozen pizza. We’ll call this the ‘Bachelor 30” market index.
The next friend comes back with 25 different types of fruits and vegetables, plus some grain and soy-based products. Call this the “Vegan 30” market index.
Your third friend comes back with a list of thirty popular items representing every department. We’ll call this the “Kroger 30” index.
You get the idea.
In the investing world, indexes can be very influential if they become well known. Because when investors build a portfolio. they often like to have a model, or list, to make it easy to choose which stocks to buy.
So if an index is widely followed, the stocks in that index get lots of attention and lots of buyers (or sellers, if the market is on the way down). Those indexes become a ‘benchmark’ for investors, who always try beat the average (or certainly do no worse than it).
Indexes can be broad (like the ‘Kroger 30’) or narrow (like ‘Vegan 30’). There are thousands of them, focused on everything from the largest companies (e.g. S&P 500), to tech (e.g. Nasdaq composite) to healthcare, utilities, real estate, and everything else. Specialized companies (like S&P and MCSI) create these indexes, and then license them to investment firms.
So next time you hear about the Dow Jones Industrial Average or the S&P 500, at least you’ll know what they’re talking about. They’re just lists of stocks… but influential ones.