How to use indexes

You may be wondering what to do with all the indexes out there and which one or ones you should be checking out. The sections below give you some idea of how to put all the pieces together.

Tracking the indexes

The bottom line is that investors get an instant snapshot of how well the market is doing from indexes. Indexes offer a quick way to compare the performance of one investor’s stock portfolio or mutual funds with the rest of the market. If the Dow goes up 10 percent in a year and your portfolio shows a cumulative gain of 12 percent, then you know that you’re doing well.

The problem with indexes is that they can be misleading if you take them too literally as an accurate barometer of stock success. The Dow, for example, has changed its roster of companies many times since 1896. Had it not, the Dow’s general upward trajectory in the past few decades would have been much different. Laggard stocks have been dropped and replaced with other stocks that have shown more promise. Many of the original companies that were in the DJIA in 1896 did go out of business, or other companies, that aren’t reflected in the index, bought them out.

Investing in indexes

Can you invest directly in indexes? If the market is doing well but your specific stock is not, can you find a way to invest in the index itself? With investments based on indexes, you can invest in the general market or a particular industry.

Say that you want to invest in the DJIA. After all, why try to “beat the market” if just matching it is sufficient to grow your wealth? Why not have a portfolio that directly mirrors the DJIA? Well, it’s too impractical and expensive to invest in all 30 stocks that are in the DJIA. Fortunately, there are alternatives that can accomplish the act of “investing in indexes.” Here are the best ways:

Index mutual funds: An index mutual fund is much like a regular mutual fund except that it will only invest in securities (in this case, stocks) that match as closely as possible the basket of stocks that are in that particular index. There are index mutual funds, for example, that track the DJIA and the S&P 500. Find out more about index mutual funds at places such as the Investment Company Institute (www.ici.org).

Exchange Traded Funds (ETFs): This is a particular favorite of mine. ETFs have similar characteristics to a mutual fund except for a few key differences. An ETF can reflect a basket of stocks that mirror a particular index, but the ETF can be traded like a stock itself. You can transact ETFs like stocks in that you can buy, sell, or go short. You can put stop losses on them and you can even purchase them on margin. ETFs can give you the diversification of mutual funds coupled with the versatility of stocks. Examples of ETFs that track indexes are the DJIA ETF (symbol DIA) and the ETF for Nasdaq (QQQ). You can find out more about ETFs at the American Stock Exchange (www.amex.com).