A stock index is a way to evaluate the performance of part or all of the stock market, typically by assessing the average behavior of the stocks that make up that index. But stock indices aren't just useful as a measurement tool; they can be a powerful investment tool as well.
Index mutual funds and ETFs seek to mirror the performance of a particular stock index by holding the stocks that make up that index. Because the index simply tracks a certain set of stocks, there's much less need for the fund manager to get actively involved in trading decisions, so fees and commissions are typically far lower than fees and commissions in an "actively managed" mutual fund -- and index funds have far fewer transactions as well, meaning you'll save on capital gains taxes.
All in all, deciding to go with an index fund is the easy part; the challenge is figuring out which index would be the best one for you to follow. Here's a list of some of the most significant indices and why you might want to choose each.
Dow Jones Industrial Average (DJIA)
The Dow Jones Industrial Average (DJINDICES: ^DJI) is one of the oldest stock indices and is still one of the most widely used today. It tracks the stocks of 30 of the largest and most influential businesses in the US, which currently includes Apple, ExxonMobil, McDonald's, and Walt Disney.
The Dow is a price-weighted index, meaning that component stocks with higher share prices are given more weight than the lower-priced stocks. Because the Dow consists entirely of very large, established businesses, it's a good choice to follow for someone who is looking for blue-chip companies to invest in. The Dow makes up roughly 1/4th of the entire US stock market, and it tends to fluctuate in sync with the market as a whole.
Nasdaq Composite Index
The NASDAQ (NASDAQ: NDAQ) is a stock exchange that emphasizes technology stocks, and the Nasdaq Composite Index includes every stock on this exchange.
Unlike the Dow, it's a market-capitalization-weighted index, meaning that the stocks in this index are weighted by the total dollar value of each company's shares. Thus, bigger companies are given more weight than smaller ones.
Like the exchange it's based on, the Nasdaq Composite Index has a heavy emphasis on technology and biotech stocks, but also includes some stocks from other sectors, including financial, transportation, and industrial stocks. It also includes some penny stocks. Thus, an index fund following the Nasdaq Composite Index will do well when the technology sector as a whole thrives. If you're looking for a fund based on the technology sector, this index is a good one to choose.
Standard & Poor's 500 Index (S&P 500)
The first-ever index fund (the Vanguard 500 Index Fund (NYSEMKT: VOO)) used the S&P 500 as its index. The S&P 500 tracks the performance of 500 of the most widely traded stocks in the United States and makes up about 80% of the value of the entire US stock market.
This index is a market-capitalization-weighted index, and includes stocks from a wide range of sectors. The S&P 500 tends to move in line with the market as a whole even more closely than the Dow, so it's a great choice for investors looking for an index that will mirror the entire US stock market's behavior.
The Russell 2000
The Russell 2000 (RUSSELLINDICES:^RUT) index is a subset of the Russell 3000 index. The Russell 3000 tracks the largest publicly traded companies in the US market; the Russell 2000 tracks the 2000 smallest companies within the Russell 3000. Thus, the Russell 2000 index has become a widely used benchmark for the performance of smaller US companies, also known as small-cap stocks.
Small-caps tend to be more volatile than large-caps, but they also tend to perform slightly better over the long haul. An investor looking for an index fund or ETF that will have slightly higher risk but will maximize potential returns should consider one following the Russell 2000 index.
Morgan Stanley Capital International Europe, Australasia, Far East (MSCI EAFE) Index
The MSCI EAFE (NYSEARCA: EFA), unlike the previously mentioned indices, tracks the stocks of non-US- based companies. Specifically, it tracks stocks of companies based in Europe, Australasia, and the Far East. This index includes the most developed regions outside of North America, with countries that tend to have stable governments and economies in line with the US's. Thus, index funds that track this index provide a relatively low-risk way to invest internationally.
All of the above?
Diversification is the key to minimizing risk and maximizing returns over the long haul. Investing in index funds rather than individual stocks is a step in the right direction, but you can diversify further by choosing two or three different indices to invest in.
Selecting indices that reflect widely varying types of stocks will help protect you from poor performance in one sector or region of the market. For example, choosing a Dow index fund and an S&P 500 index fund won't really help you diversify because those indices tend to behave similarly. But if you choose a Dow index fund and a Russell 2000 index fund, you'll be doing a much better job at diversifying: the Dow tracks very large companies while the Russell 2000 tracks small-cap companies. Throw in an international index fund as well, and your diversification will become global. Whatever the economy throws at you, such a well-diversified portfolio will help you to survive unscathed.