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.
Related Terms
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
- Investopedia on Indexing
- Wikipedia Entry on Index Fund
- Bureau of Labor Statistics on Consumer Price Index (CPI)
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
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