There are advantages and disadvantages to using stock indexes and the index funds that track them. An index is an imaginary portfolio of securities representing a particular portion of the broader market. The stock index can provide a statistical measurement of the stock prices in that portfolio. An index is typically constructed using the shares of leading companies in the economy or in a particular sector.
Key Takeaways
- An index gives a quick measure of the state of a market.
- Index funds are a low-cost way to invest, provide better returns than most fund managers, and help investors to achieve their goals more consistently.
- On the other hand, many indexes put too much weight on large-cap stocks and lack the flexibility of managed funds.
- Several prominent investors and numerous respected academics believe most people are better off with index funds.
Indexes first became popular with the Dow Jones Industrial Average (DJIA), which was created by Charles Dow in 1896. The DJIA was the second stock index, created after the Dow Jones Transportation Average. The DJIA became a crucial tool for tracking the strength of the broader economy. Since then, other stock indexes have become popular, including the S&P 500 and the NASDAQ Composite. Many indexes track other asset classes, such as bonds and commodities.
Numerous low-cost index funds track stock indexes. Some prominent investors, such as Warren Buffett, have championed the use of index funds for the average investor.
Advantages of Indexes
Stock indexes provide an easy way to track the overall health of a market. By looking at one statistical measurement, it is easy to gauge the current state of the market. Further, the historical data of index movements and prices can provide some guidance to investors as to how the markets have reacted to specific situations in the past. That can help investors to make better decisions.
Advantages of Index Funds
There are also several advantages to index funds. The main advantage is, since they merely track stock indexes, they are passively managed. The fees on these index funds are low because there is no active management. Exchange traded funds (ETFs) are often index funds, and they generally offer the lowest fees of all. That can save investors money over the course of their lives since less of their investment gains go toward fees and expenses.
Academic studies have shown index funds outperform active management funds over time. Even a manager who consistently beats the market can show diminishing performance. Thus, it often makes sense for many investors to include index funds as a portion of their portfolios.
Another benefit of index funds is that they allow investors to achieve their goals relative to benchmarks more consistently. For instance, consider an investor who wants to beat the market and is willing to take more risks to achieve that goal. Investing 90% in a low-cost S&P 500 ETF and 10% in a 2x S&P 500 leveraged ETF will often beat the market. There is no risk that a fund manager picks the wrong stocks with this approach. The only risk remaining is when poor or mediocre market returns cause leveraged ETFs to underperform the market.
Diversifying stock holdings with ETF index funds in other asset classes can reduce the volatility of a portfolio. Government bond funds often provide a good hedge against stock market declines.
Disadvantages of Indexes
There are issues with the calculation of stock indexes that can lead to disadvantages. For example, the DJIA is a price-weighted index. The index is calculated by taking the sum of the prices of all 30 stocks in the index. This sum is then divided by a divisor. The divisor is adjusted based on stock splits, spinoffs, or other changes in the market.
Stocks with higher prices have a larger impact on movements in the index as compared to lower-priced stocks. As a price-weighted index, no consideration is given to the relative size of the industry sector of the stock or its market capitalization. Another criticism of the DJIA is that it represents a thin slice of the blue-chip universe since it contains only 30 companies.
On the other hand, the S&P 500 is a market-cap-weighted index. It is calculated by taking the adjusted market capitalization of all the stocks in the index and then dividing it by a divisor. Similar to the DJIA, the divisor is adjusted for stock splits, spinoffs, and other market changes. The main drawback to the S&P 500 is that the index gives higher weights to companies with more market capitalization. The stock prices for Apple and Microsoft have a much greater influence on the index than a company with a lower market cap. The S&P 500 index does not provide any exposure to small-cap companies, which historically produced higher returns.
Disadvantages of Index Funds
There are also disadvantages to using index funds for investments. The lack of flexibility limits index funds to well-established investment styles and sectors. Furthermore, stock indexes experienced a great deal of volatility in 2020. The index funds merely followed the stock indexes downward. However, a good active manager may have been able to limit the downside by hedging the portfolio or moving positions to cash.
Another key drawback of index funds is the inability to duplicate the most successful fund managers' approaches. While there are many choices for value investing ETFs, there are far fewer growth at a reasonable price (GARP) ETFs. Furthermore, GARP ETFs seem unlikely to duplicate the long-term performance of a master of that style, such as Peter Lynch. Finally, fund managers are constantly devising new strategies. Even the most successful strategies will not spawn ETF imitators for years to come.
FAQs
The advantages of indices are that they focus on key variables, while the disadvantages include their abstract nature, tendency to skip unmeasurable determinants, and their application of a single yardstick to diverse countries and regions.
What are the advantages and disadvantages of indexes? ›
Index funds are a low-cost way to invest, provide better returns than most fund managers, and help investors to achieve their goals more consistently. On the other hand, many indexes put too much weight on large-cap stocks and lack the flexibility of managed funds.
What are the negative effects of indexes? ›
While indexes are invaluable for improving query performance, there are downsides. Every index added to a table increases the storage space required by the database. Additionally, indexes can slow down write operations such as INSERT, UPDATE, and DELETE, as each operation requires updating the indexes.
What are the benefits of using indexes? ›
Indexing can provide several advantages for your database, such as faster query execution, reduced disk input/output operations, optimized query plans, and enhanced data quality. Indexes can help the database find the data you need quickly without scanning the entire table.
What is the disadvantage of an index? ›
The first and perhaps most obvious drawback of adding indexes is that they take up additional storage space. The exact amount of space depends on the size of the table and the number of columns in the index, but it's usually a small percentage of the total size of the table.
What are the advantages and disadvantages of index options? ›
Index trading can have multiple benefits. Some of them are: Hedging and Speculation: Investors use index options to gain exposure to the entire market or industry sector through a single transaction. Limited Loss, Unlimited Gain: Loss is capped at the premium paid, while the potential for gains is unlimited.
What are the advantages and disadvantages of index file? ›
The main advantage of indexed file access is its speed and efficiency for random and sequential access operations. But, its main disadvantage is that it requires additional storage space for the index, which can increase the cost and complexity of the system.
When should indexes be avoided? ›
While indexes are designed to improve the efficiency of a database, there are occasions where they should be avoided, for instance:
- On small tables.
- Tables that receive a lot of big batch updates or inserts.
- Columns that have large numbers of null values.
- Columns that are frequently manipulated.
Indices speed the retrieval of data but inserts, updates rely on them to locate and find the correct value to add or update records. Also indices take up storage, not much, but managing that takes time. So speed is the number one parameter affected by too many indices.
What are the negative indexes? ›
Negative indices are powers (also called exponents) with a minus sign in front of them. E.g. We get negative indices by dividing two terms with the same base where the first term is raised to a power that is smaller than the power that the second term is raised to. E.g.
An index is a list of all the names, subjects and ideas in a piece of written work, designed to help readers quickly find where they are discussed in the text. Usually found at the end of the text, an index doesn't just list the content (that's what a table of contents is for), it analyses it.
Why do people use indexes? ›
Indexes are useful for providing valid benchmarks against which to measure investment performance for a given strategy or portfolio. By understanding how a strategy does relative to a benchmark, one can understand its true performance.
What are the advantages and disadvantages of market index? ›
The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification. Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).
What are the advantages and disadvantages of using indexes? ›
The advantages of indices are that they focus on key variables, while the disadvantages include their abstract nature, tendency to skip unmeasurable determinants, and their application of a single yardstick to diverse countries and regions.
What are some limitations of the index? ›
Limitations of Index numbers
- Provides Relative Changes only: Index Numbers estimate relative changes only and cannot speak the truth as they are only approximate indicators. ...
- Lack of Perfect Accuracy: ...
- Ignores Qualitative Changes: ...
- Possibility of Manipulations: ...
- Difference between purpose and method of Construction:
The further from the base year, the more inaccurate is the index number likely to become, for the basket is more liable to change. Moreover, since patterns of expenditure vary in different localities and different countries, an index number has very limited value in comparing price changes in different places.
What is index number advantages and disadvantages? ›
The index numbers show the approximate indications of the relative changes that occur. Moreover, the changes in variables that are compared over a prolonged time may fall short on reliability. The selection of representative commodities may be skewed. It is since these commodities are based on samples.
What are the advantages of index function? ›
By utilizing indexing, the "len()" function can efficiently determine the size of a data structure without iterating through every element. In addition to these advantages, indexing also plays a crucial role in iterating over data structures using loops.
What are the disadvantages of index selection? ›
However, its major disadvantage is that the weightings assigned to each characteristic are inherently quite hard to calculate precisely and so require some elements of trial and error before they become optimal to the breeder.
What are the disadvantages or costs of index? ›
The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification. Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).
