Index Investing: 5 Ways to Identify a Good Index

Part of the Index Investing For Dummies Cheat Sheet

An index investment is only as good as an index fund, and an index fund can be only as good as the index behind it. So what's an index? It's a standard measure of the changes in performance within a grouping of stocks; this group serves as a benchmark for the stock market as a whole or for particular parts of the market. You can't invest in an index because it's a mathematical measure.

Examples of indices include the Dow Jones Industrial Average and the S&P 500 in the United States, Japan's Nikkei 225, and the British FTSE 100. (The numbers represent the number of stocks within that particular index.)

Following are five ways to recognize quality in an index:

  • A good index is transparent. You know exactly how many securities it holds and exactly what kinds of securities those are.

  • There is minimal turnover. If half the securities in the index need to be replaced every year, the fund manager tracking the index will have to do a lot of buying and selling. That raises your costs and sets you up for a nasty tax bite.

  • The index is logical. Securities are chosen by some objective measure, not by some kind of popularity contest that resembles a high school yearbook committee's choice of best-looking.

  • Breadth is best. The index includes enough securities to accurately represent a particular market, and the broader the market, the better. Ten stocks or bonds do not represent a market. An index should represent a good portion of the economy.

  • The index is relevant to the real world. Is the index tracking something that makes sense in your portfolio? An index that tracks the price of pickled beets or grass seed may be interesting, but do you really want to stake your retirement on it?

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