Episode 61 – What Is An Index? How are they calculated? Should I care?

Hi everyone and welcome to another wealthy and wise Wednesday. Well, as promised from our last episode, we are going to talk about indexes and what an index is and why you might want to pay attention every once in a while to what is going on in the index. So what is an index? The most famous one is called the Dial Jones Industrial Average (DJIA) you might have seen that a time or two or every time you turn on the news, you might have seen it and what that basically means just so you know. This is only 30 companies, this is 30 large, stagy, what I often referred to as blue chip companies.

[00:00:49] and they have what is called a weighted index, okay. So, there is a difference between a weighted and an un weighted index. Most by the way are what are called weighted. So here is how it would work, let just take the dial Jones because there is only 30 stocks in there. Basically you take the total market capitalization of each stock, so market capitalization is basically the number of shares that are outstanding and the current price. So if a company has a thousand shares out there and the current share price is 10, we know that the market cap for that company is 10,000 dollars. All the shares added up and so today’s market price will tell us the market capitalization for that company.

[00:01:45] so often referred to as the market cap, what we want to know of the market cap is really what the company’s total value is. So what the Dial Jones industrial average does is it adds up the market cap or the value of all 30 companies and then divide it by 30 and that essentially gives us a weighted average of each of the different companies. So if we have them all added up and the equal I don’t know a 100 to make it easy, they divide it by 30 and that is what gives us kind of that weighted average between each one of the stock companies.

[00:02:29] Now the S and P 500 is also a weighted index which means that, well let’s just talk about some of the companies in there. The largest company in there, actually the largest company in the world and one we talked about a few weeks ago is Apple. It had over a trillion dollars in market cap or value, it is the number one stock in S&P 500, number one stock as far as market cap all over the world. Then we got Microsoft in there, we got Amazon in there, we got Facebook in there. Here it is really interesting, all four of the top five companies are tech companies and relatively young by you know standard of like Johnson and Johnson [00:03:20] IBM things like that.

[00:03:24] so these companies just came on and came on strong, you can tell how important tech is to the world. Anyway, so Apple, Microsoft, Amazon, Facebook the top four companies in the S&P 500. Then we have Bookshire hathway. Now what is Bookshire Hathway? Maybe you have heard it, maybe you don’t know really know what that is, that is Warren Buffet company, this is where he made all his purchases. So Bookshire Hathway owns companies like Gaiko, Seize-candy, Coca-Cola and so when Warren Buffet decides on what company he wants to buy, they buy it out of Bookshire Hathway. So Bookshire Hathway technically owns the stock or those companies outright. And then Bookshire Hathway is back sold just like any other stock, you and I can go in and buy Bookshire Hathway stock and essentially own Geiko and Seize candy and Coca cola and so on.

[00:04:27] Interesting and I think we have said this many times, Bookshire Hathway sitting on over a 100 billion dollars in cash waiting for some kind of opportunity or at least some better price on what is going in the market today. Well, we have got JP Morgan Chase, that is number six on the six, then alphabet, do you know what Alphabet is? I don’t know if you know this or not but Alphabet is actually Google but its corporate name is Alphabet. Then we got Johnson and Johnson, Exon mobile, rounding up the top ten. Then we have some banks, Bank of America, Wells Fargo moving up right behind.

[00:05:15] So those are kind of the largest market capitalization companies likely in the world. So what a weighted index is it takes all those 500 different companies, add them up together in market capital and divide it by 500 and that gives us a weighted number, that gives us a value. So here is the problem with the weighted index, it is that the biggest company have more of an effect if you will on the S&P or on the Dial because they are both weighted. So if Apple really have a great year because it so much larger than any of the companies in the index, it can pull them along and make it look like the whole market doing well when potentially maybe it is just the top few companies that are doing well and conversely if Apple stocks have a bad week, month, year, that can have a drag on the whole index not proportion to what is going on with the other companies.

[00:06:34] In those 500 companies, we can still have companies doing very well but because the big boys aren’t doing so well, it is dragging the entire index down. And this of course has been a problem with weighted indexes since the beginning of time because one or two companies can pull or decline those values pretty quickly. So what is un-weighted index? There are actually awesome out there, they are not followed all that well but there is actually an S&P 500 equal weight index as well and essentially what they do is they just take, it doesn’t matter what the market capitalization is, they just take 0.2% of every company. So it doesn’t matter how big you are 0.2% of your shares are going to be represented in this index and that gets weighted to 100% and at that 100% level that is how we can see whether or not the market has a whole.

[00:07:41] It is going to be a much more effective way to see how more or fewer stocks are doing well versus just the one or two or five or ten that can pull a market along pretty easily. So it is probably a good idea to get an idea of what the equal weight index is versus what a weighted index is and quite honestly right now with the market in this past few year, just pretty much going forward, they are going to look quite the same and where that might change is like I say if some of these big boys start to take a little breather, take a little decline but even some of the smaller companies still doing well and moving well. Then an equal weighted index is probably not going to look quite as bad as the weighted index.

[00:08:38] Okay, wow, that is probably more information than you wanted to know on indexes but I think it is kind of critical to know what is going on so you can access when a market, is it dropping because just a few of the big boys are having some troubles or is it dropping because the whole economy and everything really having an event so to speak. So keep your eyes on the weighted and an equal weighted index, just for comparison especially next time we have some kind of a correction or a drop.

[00:09:13] Now why is the index important? One is it is a very popular place to invest money, people who just don’t necessary know what to do with their money typically can but into an index. The other that has made them very popular is that they are so cheap, the fees are very little especially in an ETF which is an Exchanged Traded Funds, you can get in those for pennies, you do not need a broker, you do not a financial advisors and in fact, there is a good chance your financial advisor isn’t going to be the index anyway and so having somebody diversify and do all those things for you and pretty much fall short of the index. Well, that is why Buffet and many recommended that if you don’t know what you are doing just get involved in the index.

[00:10:03] So the index is very popular for a lot investor, especially those that don’t want to understand or learn or really do much, they just kind of want to put their money away and hope for the best. An index can be a good resource or a good alternative for that. The other thing is, that is how we weight whether or not market is doing well, that is how we kind of get a sense of should I be panicking, should I be greedy, right? We should always be looking at this market as opportunity and when others are very greedy and keeps buying and pushing this market up, that is when we probably want to be a little fearful. Sometimes we are fearful on a wrong in for many years, I mean 3,4 years or 5 years, we could be sitting on the sidelines because this thing just gets pushed up more and more and more.

[00:11:03] then the opposite happens, when the market is getting pushed down and people are fearful and they are selling out, this is where we want to start picking off the cherries and make sure we are buying good companies at a very good price and taking advantage of those events of those opportunities. Just literally the opposite of what probably 99% of your co-workers and people you know and your neighbors do. They are continually buying and putting into this market even though it is picking out and PE ratios and things like that or out of this stratosphere, they are still euphoria. And I am not saying that is not going to last for a while, it could but this market, there is a lot of power behind it, lot of good things going on, so I can’t really say that it is on its way down because I don’t know when that is going to happen, I just know that if Buffet send there with a 100 billion dollars, he probably feels that there is a very angst to trying to get involved in this market when it could potentially be overvalued.

[00:12:19] and it is certainly over valued I mean I look all the time trying to find something of value and it is really hard and so you sit on the sidelines which makes our banking system even the more popular and works well because at least we are doing something with our dough while it is populating and growing until our opportunities come along. And this doesn’t matter if it is in stock or if it is in oil, if it is in gold, if it is real estate, whatever it is, we just always wanted to be ready for an opportunity and the only way to do that is to have some capital. What is happening though is everybody is going to ride and their capital is going to look really good and they are going to have all this money and then they are going to ride the rollercoaster down and who knows.

[00:13:09] we saw 401k’s turning to 201K’s we saw market drop 50% and then that is when we kind of want to get excited and maybe look some opportunities, so in the meantime, I hope this has been helpful, that is an index, that is the differences, watch for both of them. Maybe put on your radar a weighted index and an unweighted index, just so you kind of see how they run in comparison to one another but know that when the S&P or the [00:13:40] are moving forward, there is a good chance they are getting pulled by the top 2, 3, 5 companies that are just doing very well and when those things do break and they start to drop off the planet, there could still be some values in the one behind because they are not necessarily having the struggle that big boys are, that are pulling down the average.

[00:14:04] Alright, little more technical maybe that you are used to but if you have any questions, always shoot them out to questions@wisemoneytools.com Love to hear your comment, your suggestions, even your snide remarks and if you have any incline that you want to talk about this kind of stuff, have a little strategy session, feel free to reach out, we will make sure that happens as well. So that is about it, talk to you next week, take care.

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