Since nearly every media outlet on the planet reported the news, you probably already know that the FTSE 100 Index topped 7,350 for the first time on 13th January 2017 (the U.S Dow Jones Index also surpassed 20,000 on 25th January 2017).

But when a popular index like the FTSE is on a tear, up or down, what does it really mean to you and your investments?

Great question. In this multi-part series, I’m going to cover some of the ins and outs of indexes and the index funds that track them.

What is an Index?

Let’s set the stage with some definitions.

An index tracks the returns generated by a basket of securities that an indexer has put together to represent (“proxy”) a particular swath of the market.

Some of the familiar names among today’s index providers include the FTSE Russell, S&P Dow Jones, MSCI and Wilshire. It’s perhaps interesting to note that some of the current index providers started out as separate entities – such as the FTSE and Russell and S&P and the Dow – only to consolidate over time. In any case, here are some of the world’s most familiar indexes (with “familiar” defined by where you’re at):

• FTSE 100 (U.K.)
• S&P 500, Nasdaq Composite, and Dow (U.S.)
• S&P/TSX Composite Index (Canada)
• MSCI EAFE (Europe, Australasia and the Far East)
• Nikkei and TOPIX (Japan/Tokyo)
• CSI 300 (China)
• HSI (Hong Kong)
• KOSPI (Korea)
• ASX 200 (Australia)
…and so on

Why do we have Indexes?

Early on, indexes were designed to offer a rough idea of how a market segment and its underlying economy were faring. They also helped investors compare their own investment performance to that market. So, for example, if you had invested in a handful of U.K. stocks, how did your particular picks perform compared to an index meant to track the average returns of U.K. stocks? Had you “beat the market”?

Then, in 1976, Vanguard founder John Bogle launched the first publicly available mutual fund specifically designed to simply copy-cat an index. The thought was, instead of spending time, money and energy trying to outperform a market’s average, why not just earn the returns that market has to offer (reduced by relatively modest fund expenses)? The now familiar Vanguard 500 Index Fund was born… along with index fund investing in general.

There are some practical challenges that prevent an index from perfectly replicating the market it’s meant to represent. We’ll discuss these in future segments. But for now, the point is that indexes have served investors across the decades for two primary purposes:

1. Benchmarking: A well-built index should provide an approximate benchmark against which to compare your own investment performance… if you ensure it’s a relatively fair, apples-to-apples comparison, and if you remain aware of some of the ways the comparison still may not be perfectly appropriate.
2. Investing: Index funds that replicate indexes allow you to indirectly invest in the same holdings that an index contains, with the intent of earning what the index earns, net of fees.

Indexes are NOT predictive

There is also at least one way indexes should NOT be used, even though they often are:

Index milestones (such as “Dow 20,000”) do NOT foretell whether it’s a good or bad time to buy, hold or sell your own investments.

Indexes don’t tell us whether the markets they are tracking or the components they are using to do so are over- or under-priced, or otherwise ripe for buying or selling. Attempting to use current index values as a way to time your entry into or exit from a market does not, and should not replace understanding how to best reflect your unique investment goals and risk tolerances in an evidence-based investment strategy.

In fact, market-timing of any sort is expected to detract from your ability to build wealth as a long-term investor, which calls for two key disciplines:
1. Building a cost-effective, globally diversified portfolio that exposes you to the expected returns you’d like to receive while minimising the risks involved
2. Sticking with that portfolio over the long run, regardless of arbitrary milestones that an index or other market measures may achieve along the way

As one commentator observed the day after the Dow first broke 20,000: “Sensationalism of events like these [Dow 20,000] has the ability to trigger our animal spirits or our worst fears if we don’t have a long-term investment plan to keep them in check.”

What this means for you

So first and foremost, have you got those personalised plans in place? Have you constructed a sensible investment portfolio you can adhere to over time to reflect your plans? If not, you may want to make that a top priority. Next, we’ll explore some of the mechanics that go into indexing, to help put them into the context of your greater investment management.

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