What is Indexes?

An index is a statistical yardstick used to gauge the performance of a particular market or group of investments. By tracking average prices or the movement of prices of a group of similar investments, such as small or large company stocks or corporate bonds, an index produces a benchmark measure against which you can assess an individual investment’s performance.

Think of using an index the same way that you may use a list of comparable home sales when you shop for a house in a neighborhood. If the list of comparable homes shows you that the average three-bedroom colonial sells for $189,000, you can’t expect to buy a similar house for too much less than that. At the same time, you don’t want to pay too much more. In the same respect, the benchmarks produced by an index show you a reasonable performance target. A return is an investment’s performance over time. If you’re looking at performance for a period of time, say five years, look for an average annual return. If the same mutual fund returned 10% over the course of those five years, its average annual return would be 10%. Its cumulative return, which simply totals an investment’s performance year after year, would be 50% for those five years.

If an investment’s performance over the course of a year is vastly superior or inferior to the appropriate index’s return, you’ll want to know why. Your investment may be outpacing its peers because it’s a lot riskier. A mutual fund, for example, may invest in stocks or bonds that are far riskier than other funds it may resemble. On the other hand, an investment may be lagging its peers simply because it’s a poor performer. Bear in mind, however, that you have to build a performance history over time to determine the character of a particular investment. Notice that in Figure 8-1, the mutual fund is performing below average, which may prompt you to sell that investment.

The following sections offer a look at the indexes that are likely to come in handiest as you try to determine expected performance from your investments.
Start by tracking an index that represents or follows your stock or mutual fund. After you become familiar with that index, then pick up another index to follow. Be careful not to follow too many indexes, though — it can become confusing and time-consuming.