Imagine you are an apple farmer, and you have a bunch of acres and thousands of apple trees.
Side note, have you had a Honeycrisp apple?! These things are amazing. I should know; I’m from Washington State, the land of angst-filled musicians, rain, and apples.
In your apple orchard, you have different types of apple trees and millions of apples. You’ve got a lot riding on this harvest. If they turn out sweet and crisp, you will make a lot of money. If they are a bit mushy, you’ve got problems. But how can you know? Well, I suppose you could pick every apple and take a bite of each one to see if it’s a good apple. But that’s not going to work too well.
What else could you do?
You could pick an apple from each different type of apple tree in your orchard. You’d pick some apples from your Honeycrisp trees and some apples from your Granny Smith trees, etc. You’re basically taking a sample from each tree so you have a good indication of how each type of apple is doing. It’s quick and it gives you a pretty good idea of how all the apples are doing.
That’s what a stock index is. It’s a basket of stocks.
For example, the Dow Jones Industrial Average is an index. It only has 30 stocks in it, and it tries to represent how large companies in the U.S. are doing. There are thousands of large U.S. companies, but the Dow has just 30, and these 30 give us an idea of how they are all doing.
An index is just a collection of investments.
There are many indexes out there that contain almost any type of investment you could imagine. There’s an index of oil companies, small Russian companies, Chinese technology companies, high yield bonds, municipal bonds, and on and on.
This way, you can look at the different parts of the market and get a good idea how each has done. You can quickly look at an index and see that bonds from emerging markets are not doing well, but restaurant company stocks in the U.S. are doing great.
So that’s one reason an index is important, but as you’ll see later, there’s a much more important reason – a game-changing important reason.
The proceeding blog post is an excerpt from Get Money Smart: Simple Lessons to Kickstart Your Financial Confidence & Grow Your Wealth, available now on Amazon.
About the Independent Financial Advisor
Robert Pagliarini, PhD, CFP®, EA has helped clients across the United States manage, grow, and preserve their wealth for the past 25 years. His goal is to provide comprehensive financial, investment, and tax advice in a way that was honest and ethical. In addition, he is a CFP® Board Ambassador, one of only 50 in the country, and a real fiduciary. In his spare time, he writes personal finance books, finance articles for Forbes and develops email and video financial courses to help educate others. With decades of experience as a financial advisor, the media often calls on him for his expertise. Contact Robert today to learn more about his financial planning services.