With the rocky markets, many investors are looking for ways to protect themselves on the down side even if they have to give up a little upside. Index investing or indexing, is a way to invest in the markets in a style similar to an index with broad diversification.
There are several examples of indexes that you are probably already familiar with. The Dow Jones Industrial Average or DIJA, is an index. The S&P 500 is an index and the Russell 2000 is an index. An index is a representative value for a basket of stocks grouped by similar characteristics. For example, the Dow Jones contains the largest and most influential companies in the U.S. You cannot buy or sell an index because an index is only representative of a basket of stocks, it does not contain the actual stocks. Typically an index has a certain weighting scheme to it. Some indexes are weighted by market cap while others will be price weighted. The type of weighting used for the index is important to know because that way you will have an idea of what sort of actions could move the index and you can set up your index investing strategy accordingly.
There are several types of indexes and they typically have a set of rules or a guideline before a stock will be included in the index. There are sector based indexes that only allow stocks of a certain sector. A good example of this would be the Nasdaq Industrials. This is an index that only includes industrial based stocks from the original Nasdaq collection. There are also market cap based indexes like the S&P/TSX 60 which only includes large cap stocks from the S&P/TSX Composite index. There are indexes for real estate only, fixed income and strategies. When you are looking for an index to start your passive indexing strategy, it’s important that you find one that you understand and can easily find information on.
The Goal of Index Investing
The goal of index investing is to match the returns of the index. You are not trying to beat the index or underperform it; you simply want to invest in a way so that your returns match the index. The idea behind matching the index comes from the premise that no one can beat the index. Over time, anyone who tries to beat the market will only end up losing. So many people are advocates of indexing. In order to do this you can use individual stocks, ETFs or mutual funds.
Index Investing with Individual Stocks
Probably the easiest index to replicate with individual stocks is the Dow Jones Industrial Average. Because there are only 30 stocks, you could just buy a share of each of the stocks and you would be fully indexed. Another popular index is the S&P/TSX index. It includes several Canadian companies and is a broad index that is the base for many sub indexes as well. It would be a little bit harder to invest in a similar manner as this index by purchasing individual stocks because there are so many stocks that make up this index. But that is what index funds are for.
Index Investing with ETFs and Mutual Funds
Indexing with ETFs and mutual funds is probably the most popular way to build a fully indexed portfolio. There are several managers that will build a fund that mimics the returns of an index. Once again, the goal is not to beat the index but simply stay right in line with the performance of the index. Passive indexing involves consistent steady deposits and you will build your account over time.
Are you interested in following a passive index strategy? Do you use indexing for your portfolio already?
This post was written by Latisha.