Definition
What is Indexing?
Indexing is a financial strategy where individuals and institutions align their portfolios or adjust economic factors such as wages and taxes according to a benchmark or index. The aim is typically to either replicate the performance of the index or to ensure that economic adjustments keep pace with inflation or other economic measures.
For example, an investment portfolio might be structured to mimic the Standard & Poor’s (S&P) 500 Index, which comprises 500 leading publicly traded companies in the U.S. Similarly, wage agreements may be indexed to the Consumer Price Index (CPI) to ensure that wages increase in line with inflation.
Examples
Investment Portfolio Indexing
A fund manager invests in the same stocks and in the same proportion as the S&P 500. Instead of trying to outperform the market through stock picking, this passive investment strategy aims simply to match the market performance.
Wage Indexing to CPI
In a labor contract, an agreement may stipulate that wages will be adjusted annually based on the percentage change in the CPI. This ensures that workers’ earnings keep up with the cost of living.
Frequently Asked Questions
What is the benefit of indexing an investment portfolio?
Indexing an investment portfolio reduces management fees and operational costs compared to actively managed funds. It provides diversified risk and ensures that the performance tracks a well-regarded benchmark, usually aligning with overall market growth.
How does wage indexing help employees?
Wage indexing protects employees’ purchasing power by ensuring wages are adjusted for inflation, thus preventing real income from eroding over time due to rising prices.
Can taxes be indexed too?
Yes, taxes can be indexed to inflation to ensure that tax brackets are adjusted so that taxpayers do not face “bracket creep.” Bracket creep happens when inflation pushes taxpayers into higher tax brackets despite not having increased their real income.
What are common indexes used for indexing?
Common indexes include the S&P 500 for investment portfolios, the Consumer Price Index (CPI) for wage adjustments, and other specialized indexes for different economic indicators.
Consumer Price Index (CPI)
The Consumer Price Index measures the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
Standard & Poor’s 500 Index (S&P 500)
An index of 500 leading publicly traded companies in the U.S., widely regarded as one of the best measures of large-cap U.S. equities.
Online References
Suggested Books for Further Studies
- “A Random Walk Down Wall Street” by Burton G. Malkiel
- A guide to index investing and other investment strategies.
- “Unconventional Success: A Fundamental Approach to Personal Investment” by David F. Swensen
- A case for index fund investment strategies.
- “Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor” by John C. Bogle
- Insight into the advantages of indexed investing and mutual funds.
Fundamentals of Indexing: Finance Basics Quiz
### What is the primary goal of indexing an investment portfolio?
- [x] To match the performance of a specific market index.
- [ ] To outperform the market index.
- [ ] To mitigate all investment risks.
- [ ] To exclusively invest in government bonds.
> **Explanation:** The primary goal of indexing an investment portfolio is to match the performance of a specific market index, typically through a passive investment strategy.
### How does wage indexing to CPI affect an employee's earnings?
- [ ] It reduces their real income over time.
- [x] It adjusts wages to keep pace with inflation.
- [ ] It fixes their earnings regardless of inflation.
- [ ] It decreases the burden of taxes on their wage.
> **Explanation:** Wage indexing to CPI ensures that the employee's earnings are adjusted in line with inflation, maintaining their real purchasing power over time.
### Which index is commonly used for indexing investment portfolios?
- [ ] Dow Jones Industrial Average (DJIA)
- [x] Standard & Poor's 500 Index (S&P 500)
- [ ] NASDAQ Composite
- [ ] Russell 2000 Index
> **Explanation:** The S&P 500 Index is commonly used for indexing investment portfolios due to its representation of 500 leading publicly traded companies in the U.S.
### What is one of the main advantages of investment portfolio indexing?
- [ ] High management fees.
- [ ] Forecasts outperforming the market.
- [x] Lower management fees compared to active funds.
- [ ] Frequent trading of securities.
> **Explanation:** One of the main advantages of investment portfolio indexing is the lower management fees compared to actively managed funds, making it cost-efficient for investors.
### Why might governments index tax brackets to inflation?
- [ ] To increase tax revenues.
- [ ] To eliminate tax brackets.
- [x] To prevent bracket creep.
- [ ] To reduce the complexity of the tax system.
> **Explanation:** Governments index tax brackets to inflation to prevent bracket creep, where inflation leads to taxpayers unintentionally moving into higher tax brackets.
### What factor does CPI measure?
- [x] The average change in prices paid by urban consumers for goods and services.
- [ ] The stock market performance.
- [ ] Employment rates.
- [ ] Interest rates by banks.
> **Explanation:** The Consumer Price Index (CPI) measures the average change over time in the prices paid by urban consumers for a specified basket of goods and services.
### Which type of investment strategy does indexing generally follow?
- [ ] Growth investing
- [ ] Value investing
- [x] Passive investing
- [ ] Speculative investing
> **Explanation:** Indexing generally follows a passive investing strategy, where the investment aims to replicate the performance of a specific index.
### What is 'bracket creep' in the context of wages and taxation?
- [ ] Artificial inflation of interest rates by banks.
- [x] Pushing taxpayers into higher tax brackets due to inflation.
- [ ] Lowering consumer prices intentionally.
- [ ] Government intervention in setting wage levels.
> **Explanation:** 'Bracket creep' refers to the situation where inflation pushes taxpayers into higher tax brackets, resulting in a higher tax liability without an increase in real income.
### How can indexing influence management fees of investment funds?
- [ ] It can increase them significantly.
- [ ] It fixes them at a high rate.
- [x] It generally lowers them due to the passive strategy.
- [ ] It has no effect on management fees.
> **Explanation:** Indexing generally lowers management fees due to the passive strategy of replicating an index rather than engaging in active management and frequent trading.
### Why is the S&P 500 considered a good benchmark for index investing?
- [ ] It is an index of bond securities.
- [ ] It only includes technology companies.
- [x] It includes 500 leading publicly traded companies providing broad market exposure.
- [ ] It focuses solely on insurance firms.
> **Explanation:** The S&P 500 is considered a good benchmark for index investing because it includes 500 leading publicly traded companies, offering a diversified exposure to the overall U.S. stock market.
Thank you for exploring our detailed explanation of indexing and testing your knowledge with our quiz. Continue to enhance your understanding of finance and investing!
