As we covered in our last piece, indexes have their uses. They can roughly gauge the mood of a market and its participants. If youve got an investment strategy thats designed to capture that market, you can see how your strategy is doing in comparison again, roughly. You can also invest in an index fund that tracks an index that tracks that market.
This may help explain why everyone seems to be forever watching, analyzing and talking about the most popular indexes and their every move. But you may still have questions about what they are and how they really work. For example, when the Dow Jones Industrial Average (the Dow) exceeded 20,000 points last January, what were those points even measuring?
An indexs total points represent a relative value for the market it is tracking, calculated by continually assessing that markets average performance.
If thats a little too technical for your tastes, think of it this way: Checking an index at any given time is like dipping your toe in the water to see how the ocean is doing. You may have good reasons to do that toe-check, but as with any approximation, be careful to not misinterpret what youre measuring. Otherwise, you may succumb to misperceptions like: The Dow is so high, it must be in for a fall. Id better get out.
With that in mind, when it comes to index points, wed like to make a few points of our own.
Indexes Are Often Arbitrary
It helps to recognize how popular indexes become popular to begin with. In our free markets, competitive forces are free to introduce new and different structures, to see how they fly. In the same way that the markets decided that the iPhone would prevail over the Blackberry, popular appeal is effectively how the world accepts or rejects one index over another. Sometimes the best index wins and becomes an accepted reference. Sometimes not.
Different indexes can be structured very differently. Thats why the Dow recently topped 20,000, while the S&P 500 is hovering in the 2,000s, even though both are often used to gauge the same U.S. stock market. The Dow arrives at its overall average by adding up the price-weighted prices of the 30 securities its tracking and dividing the total by a proprietary Dow divisor. The S&P 500 also takes the sum of the approximately 500 securities its tracking but weighted by market cap and divided by its own proprietary divisor.
With mysterious divisors, terms like price-weighted and market cap, and additional details we wont go into here, this probably still doesnt tell you exactly what index points are.
Think of index points as being like thermometer degrees. Most of us cant explain exactly how a degree is calculated, but we know hot from cold. We also know that Fahrenheit and Celsius both tell us what the temperature is, in different ways.
Same thing with indexes. You cant directly compare an S&P 500 point to a Dow point; it doesnt compute. Moreover, neither index adjusts for inflation. So, while index values offer a relative sense of how hot or cold a market is feeling at the moment, they cant necessarily tell you whether a market is too hot or too cold, or help you precisely predict when its time to buy or sell into or out of them. The compared to what? factor is missing from the equation. This brings us to our third point
Models Are Approximate
Theres an important difference between hard sciences like thermodynamics and market measures like indexes. On a thermometer, a degree is a degree. With market indexes, those points are based on an approximation of actual market performance in other words, on a model.
A model is a fake copy of reality, with some copies rendered considerably better than others. Heres what Nobel Laureate Eugene Fama has said about them: No model is ever strictly true. The real criterion should be: Do I know more about markets when Im finished than I did when I started?
According to Professor Famas description of a model, indexes have long served as handy proxies to help us explore what is going on in particular slices of our capital markets. But, they also can do damage to your investment experience if you misinterpret what they mean.
For now, remember this: An indexs popular appeal is the result of often-arbitrary group consensus that can reflect both rational reasoning and random behavioral bias. Structures vary, and accuracy is (at best) approximate. Even the most familiar indexes can contain some surprising structural secrets. In our next post, well unlock some of them for you.