What Are Stock Indexes & How Do They Affect Index Funds?

We were going to talk about indexes. What is a stock index? Well, a stock index is just a list of specific type of stocks and they're made in all kinds of different ways. You know, most of them are what is called capitalization weighted, meaning the bigger the company, the more of the index it takes up. Right? So if you're looking at Nvidia or something right now, you'll find out it's like 5% of some stock indexes because it's a really big company right now. Capitalization is the number of shares times the share price. That's the value of the company. If you wanted to buy the whole thing from all the owners, that's what it would cost you to buy. Not all stock indexes, however, are capitalization weighted. For example, the Dow Jones is not. This is the granddaddy of all stock indexes. Somebody back in, I don't know what it was, 30s, I think the 20s or the 30s sat around and said, we should make a stock index. We'll take 30 representative companies. And they were big name kind of blue chip companies and they just took. The stock price had nothing to do with the capitalization. It was like if something was selling for $2, it was $2 in the index. Something was selling for $4, it was $4 in the index. And that had nothing to do with this capitalization, just literally the stock price, which is a stupid way to make an index if you're going to, you know, really use it to track a market, much less if you're gonna design an index fund to follow it. That's one reason why it's kind of dumb to have an index fund that follows the Dow Jones. It's just dumb. Don't do that. There are lots of other indexes out there that are popular that you've heard of that maybe aren't the best ones to follow with your indexes. You know, the most common one out there is the s and P500. And you've heard of the. People say the S and P and they mean the s and P500. But they don't realize the S and P has lots of indexes. So you can't just say the S and P and assume that you're referring to the s and P500. But the S and P500 is. It's been around for quite a while. It's basically 500 large US stocks. It's not the 500 largest ones though, right? There's a committee that decides what goes into the s and P500. And 50 and when and what comes out and they announce it. And so index funds that follow this are forced to buy that stock after this announcement is made. So what happens? Well, a bunch of people go, oh, this is gonna be added to the index. A whole bunch of people are going to want to buy it. A bunch of funds are gonna buy shares of this. The price is gonna go up. Let's buy it now and front run this. And that's a problem with the S&P 500. If you're using a total Stock Market fund fund that's following a total stock market index that you've never heard of, something from MSCI or FTSE or something like that, that doesn't happen because it was already in the index even when it was a small company. And so that's one downside of something like the S&P 500. The other thing is it's technically not 100% passive to do that. Right. Because there's a committee deciding what goes into the index and what comes out of the index. Now, it doesn't have a huge effect. If you look at the correlation between the S&P 500, and the total stock market fund is pretty darn close, like 0.99. But it's not an awesome index. So I don't own index funds that follow the S&P 500. Sometimes it's all you got in your 401. If your 401 is the federal TSP, its C fund is an S&P 500 index fund. You don't have a choice. If that's where all your investments are. You have to use that and it's fine. But it's not ideal. I prefer a total stock market fund that has 4,000 stocks in it, an S&P 500 index fund that only has 500 stocks in it. You know, you get mid caps and small caps with the total market Fund, whereas you only get large caps with the S&P 500. Other indexes out there, you might have heard of the Russell 2000. This is a very popular small cap stock index. And there's lots of funds and ETFs that follow this index or a variation of it. But it's not an awesome index. It has all kinds of issues. I've written a blog post about the issues with the Russell 2000. And frankly, I wouldn't invest in an index fund that invests in the Russell 2000. I don't think it's a very good small cap index. And when you're talking about index funds, one of the things that matters the most is what index is it following the Russell 2000 for various reasons just is not a very great index. And it certainly is not an index that's designed for an index fund. Tom, to follow another one that's popular out there people talk about is basically the nasdaq, right? So you can buy an etf, very popular ETF called qqq, and all it does is follow the stocks that are traded on the NASDAQ. Now there's basically three stock exchanges in the U.S. right? You got the New York Stock Exchange and the American Stock Exchange and you got the nasdaq, right? But it doesn't really matter what exchange a stock is traded on. There's no reason whatsoever why you would be interested in index of just the stocks traded on the New York Stock Exchange or just the stocks traded on the nasdaq. It's kind of a silly way to do it. Now people got super interested in this back in the 90s because most of the stocks trading on the NASDAQ were tech stocks. And so investing in QQQ was a way to tilt your portfolio toward these high flying growthy tech stocks. It's basically the equivalent of what we call the Mag 7 today, right? All these techie stocks that have had great growth the last few years, well obviously that didn't end super well in 2000-2002. But it's just a weird way to construct a stock index, right? If you wanted a tech tilt, well buy an index that tracks all the tech companies in the world or in the US or whatever, not just the ones that are traded on the nasdaq. It's silly to do it that way. So not a great index. So pay attention to the indexes. Although these are the ones the media pays attention to, these are not the best indexes to use. When you're buying index funds. One thing you will notice they're used by, however, is the insurance industry. The insurance industry has all these index linked products and the options industry has all these products where the options are based on the indexes and they tend to use these ones. So annuities, the type you should be avoiding, cash value, life insurance, the type you should be avoiding, they tend to use these types of lousy indexes. And so those are products designed to be sold, not bought. Stay away from them. If you want to look at index funds that are designed to be used or indexes that are designed to be used by index funds, go to a place that does a good job running index funds. We're talking your Vanguard, your Fidelity, your Schwab, your Blackstreet. Those are iShares. And see what indexes their best funds are following. And those are the sorts of indexes that you want to pay attention to. Now. They're not reported on the nightly news, and so you actually have to look up fund returns on Morningstar on the website to see exactly how they're doing. But they're far better indexes. So sorry it has to be so complicated, but that's the way it is when it comes to index fund investing. Sometimes it's simpler than active management, but there's still a little bit of complexity to it.

The hosts of the White Coat Investor are not licensed accountants, attorneys, or financial advisors. This podcast is for your entertainment and information only. It should not be considered professional or personalized financial advice. You should consult the appropriate professional for specific advice relating to your situation.