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What are indices?

Imagine a food festival featuring your local eateries. They want to present not only the best they have to offer but the “eats” that make them stand out. So, they prepare a select sample of dishes representing their strongest offerings. What they’re featuring is essentially an “index” of sorts.

When it comes to “sampling” broad segments of the economy, indices are the way to go.

A stock index is like a restaurant’s sampler of top dishes

Let’s suppose you want to invest in the broader market. Buying every stock in the market is out of the question. First, it’s too expensive. Second, not all companies are worth investing in.

You might just want a sampling of the top companies that best represent the broader market. That’s what an index is for. A stock index is made up of stocks grouped together to represent a particular slice of the economy. So, you opt to buy shares of the S&P 500 instead.

If you want to narrow it down to a given sector, industry, or even commodity class, there are indices for those as well.

The S&P 500 represents the US broader market

If you want a broad measure of the US economy, the S&P 500 index gives you pretty much what you’re looking for. You get all eleven market sectors and the top 500 companies representing each sector.

The big caveat here is that not all sectors are equally weighted. Some S&P components have more index exposure than others, which you may or may not like. It’s like eating at a restaurant where some customers may think there’s too much of a given spice, or not enough of it. Everyone has their own needs and preferences.

The Dow Jones Industrial Average tells you what’s going on with blue chips

Blue chip stocks are shares of nationally recognized and financially sound companies. Many, though not all, are considered “matured” companies. All blue chips are among the largest by market capitalization.

For US markets, the Dow Jones Industrial Index is the exemplary “blue chip” index. It’s the granddaddy of all indices, as it was launched in 1896 by Charles Dow.

However, it has only 30 stocks in it. So if a few top blue chips sink, then it’s likely the whole index might take a tumble, so be careful.

The Nasdaq 100 gives you a concentrated dose of finance and tech

The Nasdaq 100 is an interesting beast. It’s very tech sector heavy but it includes companies in different sectors as well. The Nasdaq 100 is for investors who want broad market exposure with an emphasis in tech.

The Russell 2000 measures the performance of the smallest publicly traded companies

What about the “small people,” or the companies that are closer to Main Street than Wall Street? There’s an army of them in the Russell 2000. This index is made up of 2000 “small cap” companies. Although the companies in this index aren’t as well capitalized as their larger counterparts, some have been around longer than others and have the potential for growth.

Indices are also benchmarks for comparison

If a restaurant’s food is exceptional, it’s hard not to compare other restaurants, or even your own cooking, against it. This makes it something of a benchmark for comparison.

The same concept applies to investing. You can compare a stock against a given index. You can even compare your own investing performance against that of another index. Fund managers often do this, especially if their goal is to track or beat a given index.

This leads us to another idea—rebalancing a diversified portfolio of indices.

Rebalancing to seek broad market opportunities

There’s an upside to owning all four indices. For example, if you think tech might undergo an extended bear run, then you might shift to another area of focus, say, small caps or large caps. You can even spread your exposure to the broader market. If you believe all sectors are going down, then you can find another index, like commodities or currencies, that doesn’t follow the broader stock market.

The benefit of indices is that many are well-curated baskets of securities representing a given slice of the market. That’s what an index is—a selective sample of a particular slice of the market. As with the market in general, some parts will go up while others go down. But if you want to get exposure to a given market segment, then indices may be an efficient and cost-effective way to do it.

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