Between the two largest stock exchanges in the United States — the New York Stock Exchange and Nasdaq — there are more than five thousand stocks that trade during any given day. Keep in mind, those are different stocks being traded, not the number of shares exchanging hands. For reference, according to The Wall Street Journal, around 3 billion shares are traded each day on the New York Stock Exchange alone. Moreover, with so much activity throughout a single day, how can it be determined whether, or not, the market had a good day — especially when so many stocks are moving up and down simultaneously? As luck would have it, this problem has been addressed through the creation of the market index. In fact, there are multiple market indexes; the most popular two being the Dow Jones Industrial Average (DJIA or “The Dow”) and the Standard & Poor’s 500 (S&P 500).
In general, the goal of a stock index is to measure the value of a specific section of the stock market in order to get a more holistic view of its activity. Furthermore, there are indexes that focus on a relatively small number of stocks, such as The Dow which is made up of only 30 stocks. Meanwhile, there are other indexes that are made up of thousands of stocks. For instance, the Nasdaq Composite is made up of 4,000 stocks. Ultimately, these indexes provide investors with a way to track the market over time and act as a benchmark to consider while analyzing their own portfolios. At the same time, some indexes are even used to gauge the overall well-being of the entire United States economy — the S&P 500 is the most commonly used.
Fortunately for investors, following the creation of the market index came the index fund. Essentially, these funds track different stock indexes and are made up of their stocks, therefore, allowing investors to “invest in an index.” As a matter of fact, such funds have even been praised by famous investors, including Warren Buffett, for being great tools to help the average investor. That said, and as with nearly all investment vehicles, there are both pros and cons to investing in indexes.
A major positive of investing in index funds is that they are passively managed since they simply track stock indexes — which results in low fees because they do not require active management. As result, investors might save a considerable amount of money in the long-term because they will not be hit with nearly as many expenses along the way. Further, there have even been some studies that have found that index funds outperform actively managed funds over long periods of time. Consequently, it might make sense for you to consider including index funds in the diversification of your portfolio in order to hedge against your other investments.
On the flip side, there are some disadvantages of investing in index funds. One such disadvantage is that index funds offer investors little control and flexibility. Likewise, index funds (especially large ones) are exposed to the volatility of the entire market, which can lead to significant losses during times of recession. In contrast, a successful active investor could possibly lessen (or eliminate) the negative impact of a recession by making the correct choices for the situation at hand. Lastly, while index funds might provide an investor with less risk in the long-run, they also do not offer has high of an earning potential. Basically, since you are investing in the market by investing in an index fund, you do not really have the opportunity to beat the market — considering in this scenario they are one in the same.
As with any investment vehicle, index funds might be for you, but they also might not be. As such, it is always highly recommended that you do your own due diligence in order to determine if index funds will help you meet your investment goals, or not. However, whether or not you decide to invest in index funds, it is important to understand what market indexes are, how they work, and what they can tell you about the status of the United States economy. By and large, knowledge is power within the world of investing and learning more will almost certainly help you perform better!