What is an ‘Index’ in Financial Planning?

What is an Index in Financial Planning?

An index is an investing tool allowing investors to peer in past the perspex glass of investment performance, or at least a section of it.

An index is a benchmark of asset performance, and is set up to replicate a particular asset class.

 There are several types of indices:

Capitalisation indices are the most widely-known equity indices, representing total market capitalisations of all the companies inside the index. As share prices change, so does the index, with larger companies

Fixed-income indices measure the bond and short-term money market performance, and includes the S&P/ASX Australian Fixed Income Index Series and the Australian Bank Bill Index. It is used primarily by institutional investors, superannuation funds and professional financial advisers.

Residential-property indices, are, as the name suggests, a measurement of change to the residential property market. This usually uses historical returns and risks of properties in a specific location over the course of time, and this index is used by anyone involved in property – mortgage lenders, developers, owners, investors and financial advisers. One property index is the RP Data-Rismark Home Value Index.

Sector indices allow investors to benchmark a stockmarket sector or industry separately, with every company given a classification based on business activity, and these sectors are then grouped to form an index.

Strategy indices track investment strategies, so the different rules used for investing are benchmarked, and companies are selected on qualities other than the usual suspects like the company size, trading techniques and industry. Examples are the S&P/ASX Buy-Write Index and the S&P/ASX Dividend Opportunity Index.

Volatility indices, such as the S&P/ASX200 VIX is Australia’s market sentiment indicator, and is used by the media, researchers and economists to monitor volatility in the Australian benchmark equity index. It works on a 30-day basis and provides clues to investor sentiment, i.e. what investors are feeling and thinking, and therefore what their actions may be.

 So why use an index?

Investments that are based on indices give you a lot of exposure and diversification with one transaction, because otherwise you’d have to buy each stock on its own in the right ratio: expensive in both time and fees.

Indices are very broad measures of asset classes, with the methodology used to create the index published so that everyone can see exactly how it was made, and act accordingly.