First, let's review the definition of an index. An index is essentially an imaginary portfolio of securities representing a particular market or a portion of it. When most people talk about how well the market is doing, they are actually referring to an index. In the United States, some popular indexes are the Standard & Poor's 500 Index (S&P 500), the Nasdaq and the Dow Jones Industrial Average (DJIA). (Read more about the different indexes here: A Market by Any Other Name.)
While you cannot actually buy indexes (which are just benchmarks), there are three ways for you to mirror their performance:
1. Indexing: You can create a portfolio of securities that best represents an index, such as the S&P 500. The stocks and the weightings of your allocations would be the same as in the actual index. Adjustments would have to be made periodically to reflect changes in the index. This method can be quite costly, since it requires an investor create a large portfolio and make hundreds of transactions a year.
2. Buy index funds: Index funds are a cheap way to mimic the marketplace. While index funds do charge management fees, they are usually lower than those charged by the typical mutual fund. There are a variety of index fund companies and types to choose from, including international index funds and bond index funds. To learn more about the variety of indexes and the calculations involved, check out our Index Investing tutorial.
3. Index ETFs: Exchange-traded funds track an index and, like index funds, represent a basket of stocks but, like a stock, trade on an exchange. You can buy and sell ETFs just as you would trade any other security. The price of an ETF reflects its net asset value (NAV), which takes into account all the underlying securities in the fund.
Because index funds and ETFs are designed to mimic the marketplace or a sector of the economy, they require very little management. The beauty of these financial instruments is that they offer the diversification of a mutual fund at a much lower cost.