An index is a group of stocks, the performance of which is measured as a whole. Some are large, containing hundreds or thousands of companies. These are often used to gauge the performance of the overall market, as with an index such as the S&P 500 which is made up of 500 of America's biggest companies, such as Boeing, Wal-Mart, Kellogg, Ford, Citigroup, and more. Read more about the S&P 500 and Yahoo!'s (NASDAQ:YHOO) place in it in this interview with finance professor Jeremy Siegel.
Siegel explained more about index dynamics: "When [the S&P 500 managers] announce that companies are going to [be added to the index], they jump in price. Secondly, when certain sectors come into favor, their market values go up, and suddenly they qualify for admittance in the S&P 500. By the way, I have to congratulate S&P for keeping many Internet stocks out in the late '90s. They were under pressure to put more of them in. In fact, the Russell 1000 did put them in automatically. They were very reluctant to do so. Yahoo! was one of them, AOL [now Time Warner (NYSE:TWX)] a bit earlier, and then finally eBay (NASDAQ:EBAY). Because if they had put any more of those in, the S&P would have done even worse than it did since the peak of the market."
The Wilshire 5000 is an even broader market index, containing some 7,000-plus companies, almost every public company. Other indexes are smaller, or more focused, perhaps containing just small companies or pharmaceutical companies or Latin American companies.
Indexes aren't things you invest in, though. To meet the needs of people interested in investing in various indexes, index mutual funds were created. If you want to invest in a certain index, for example, you would invest in an index fund based on it. Another option, introduced more recently, is the exchange-traded fund, which offers investments based on indexes that trade like stocks.
We at the Fool have long recommended that most investors invest in index funds, since they offer a simple, easy way to roughly match the overall market's performance. Berkshire Hathaway's (NYSE:BRKa) (NYSE:BRKb) superinvestor Warren Buffett has recommended them.
Learn more about mutual finds in general in our Mutual Fund area and about Index Funds in our Index Fund area. Give exchange-traded funds some consideration, too -- they work like stocks but look like index funds.
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