What is a good index for index investing?
Before you can start investing in index fund and/or exchange traded funds that track an index, the first thing that you need to do is to choose which index or indexes to invest in.
The undeniable fact is that an index fund and/or exchange traded find that track an index can only do as well as the index, net of the expenses of the fund. As a result, the first task is to decide on which index to invest in. Not every index is born equal; there is difference in the quality among the various indexes in both United States and other countries.
There are a total of 5 factors that you need to consider when deciding on an index to track, not really only 5 but at least got these 5 factors,
1. Objective choosing of stocks for index
The stocks that made up the index need to be chosen by some objective criteria cannot anyhow chose using some imaginary and subjective measures, like choosing the winner for Miss Hong Kong.
2. Diversity of securities
One main benefits of index investing is more diversifications than actively managed mutual funds. However, there are some indexes that only consisted of ten or less stocks/bonds. This does not provide adequate safety and does not represent a portion of the economy.
As a result, it is wise to choose an index that consisted of more than enough securities to represent a sector of the economy. This is in addition to greater safety from diversification also. For example, the S&P 500 consists of 500 companies while the Dow Jones Industrial Average only consists of 30 companies, though the 30 companies are market leaders in their respective industries with large market capitalization.
3. Transparency of the index
That is for example, like the S&P500 index, how many listed companies and types of stocks.
4. Low rate of turnovers for that index
Assuming that there are objective measures for securities to be included in that index and the measures are such a way that more than half of the companies need to be changed every year based on those measures, then there will be a lot of selling and then buying being done by the fund management, this will increase the fund expenses substantially and reduces returns to investors.
As a result, choose an index with low turnover for securities in that index.
5. Relevance of index
The index needs to track something that seems to be there more than 10 years later, like General Electric and even Microsoft. An index that tracks that price of odd things like grass seed is not going to be a good index to invest in.
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