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What is an index?

Building blocks

If you want to know how global financial markets are performing, what do you do? It’s too difficult to monitor each investment within every market – there are over 2,600 companies listed on the main market of the London Stock Exchange alone. Luckily, investors can judge sentiment through the eye of an index.

Index defined

An index is essentially a list of investments selected to represent a sector or region. By looking at the performance of an index, investors can assess the health of a market and make important investment decisions. Indices are also used as key benchmarks to compare investment performance.

Reflecting sentiment within a market and tracking performance, indices have improved transparency and have made the inner workings of the financial markets easier to digest. You can easily gauge how investors feel about global events, identify when markets are in a bull or bear phase, and make crucial international comparisons – essential for when you want to build a globally diverse portfolio.

The history of the index

Whilst there are a number of prestigious indices like the S&P 500 and FTSE 100 that are monitored by an army of analysts around the globe, anyone can create an index – it really is just a catalogue of investment names.

The first index was created by founder of The Wall Street Journal Charles Dow in 1896. Wanting to provide investors with information about stocks during a highly speculative post-recession market, the journalist decided to build the Dow Jones Industrial Average, which monitored the 12 largest companies in the US.

Dow kept the calculation simple, he added up the price of each constituent of the index and divided it by 12 to show the average. Today, the Dow Jones covers 30 stocks and is less concentrated on the industrial sector.

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In general, indices are usually calculated by the member’s market value – the value of all the shares on the market. The larger the company’s market value, the bigger its percentage of the index – higher its ranking.

Today, there are a number of indices covering the global markets, including the US S&P 500, French CAC 40, MSCI family and London’s Footsie series – FTSE 100, FTSE 250 and FTSE 350. You can also get indices that reflect the bond markets and other global investments.

Exchange traded funds

After closely following the performance of an index, you want to replicate the performance of it in your portfolio. But what is the best way to do this?

Doing it yourself will take a lot of time and a lot of spare capital – not only are you going to need to cover the trading costs of buying each investment on the index, but you’re going to have to put enough money in to benefit from the diversification.

A diversified portfolio across regions and asset classes can help smooth out returns during volatile markets. If some investments in your portfolio come under pressure, gains made elsewhere should level out the performance.

For those who want to make their money work more efficiently, exchange traded funds (ETFs) are a popular choice. ETFs are a type of low-cost, passive investment that track an index or group of investments. For example, if an ETF tracked the S&P 500, it would mirror the constituents of the US index and would adjust portfolio weightings when appropriate. ETFs don’t guarantee returns, what they aim to do is deliver the same return as the market.

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