One of the simplest portfolios to assemble is one that seeks to match the performance of the stock market (as opposed to one that attempts to “beat the market”). Index funds, such as those used in SMI’s Just-the-Basics strategy, make that a relatively easy task.

Understanding index funds can be especially important to those who participate in a 401(k) plan at work. Most plans include one or more of the most common index funds among their investment options. So for the benefit of those who want to “keep it simple” in their 401(k) account, let’s take a closer look at the index-fund landscape.

When you hear or read that “the stock market was down 125 points yesterday,” it makes the market seem like a single entity, as if all stocks fell together, and presto, a loss of 125 points resulted. In reality, stocks rarely move together like that. On a “down” day, when thousands of stocks are declining in value, thousands of others may be increasing in value. Any report about how “the market” did is based on a measurement — or index — of a particular group of stocks.

Many indexes exist, each measuring how certain types of stocks are performing. Some indexes measure the performance of small-company stocks. Others focus only on large-company stocks. Still others are aimed at measuring the overall market. Indexes serve as benchmarks against which you can evaluate the performance of the stocks or mutual funds you own.

But just as learning about yesterday’s rain in Seattle won’t tell you if it rained in Atlanta, so it is with most stock-market indexes. Knowing how the largest stocks performed is of little value if you own a mutual fund that invests primarily in small companies. To get meaningful information that relates to your situation, you have to select the correct index. That means finding indexes similar to the holdings in your portfolio.

There are many mutual funds designed to mimic certain indexes (see table below). If you participate in a 401(k) retirement plan at work, chances are the plan allows you to choose from various index funds. You can learn which index a particular fund is tracking by looking at the fund’s prospectus (or the summary information provided for the fund by your 401(k)-plan administrator).

Here is an overview of the most popular indexes.

Measuring the entire market

As you can guess, an index that tracks the performance of the whole market includes thousands of stocks. What you might not know is that there are several “total-market” indexes. (Why have multiple indexes to measure the same thing? Because the companies that create these indexes are competitors. Each is trying to produce the more popular “product line” of indexes to follow.)

  • Wilshire 5000 Composite Index
    When it was created in 1974, this index covered roughly 5,000 stocks, though that number is lower today. It measures the performance of all U.S. equity securities with readily available price data. (This is why SMI uses the Wilshire 5000 as the benchmark for evaluating the performance of our model portfolios.) Like most stock indexes, this index is “market-value weighted.” The price change of a company whose total shares are worth billions of dollars will have a greater impact on the index than the price change of a company whose total shares are only worth several million dollars.
     
  • Dow Jones US Total Stock Market
    Essentially identical to the Wilshire 5000. This is a great example of each company wanting their own version of a particular index, as this index was created only after Dow Jones and Wilshire, which used to collaborate on the Dow Jones Wilshire 5000 Index, split up.
     
  • CRSP US Total Market Index
    CRSP gained notoriety when Vanguard switched away from the MSCI indexes in favor of CRSP’s indexes in 2013. This index is the benchmark for Vanguard’s popular Total Stock Market Index Fund.
     
  • Russell 3000
    Launched in 1987, this index covers about 98% of the market by tracking the 3,000 largest companies. (The primary difference between the “Total-Market” indexes above and this “Broad-Market” index is that broad-market indexes tend to leave out the smallest stocks, called micro-caps.) The Russell indexes have become popular due to their ability to offer more precise breakdowns between different kinds of companies.

Large-company indexes

The companies that comprise the “large-capitalization” (or “large cap”) indexes include many corporate household names. Their stocks often are referred to as “blue chips.” Funds that own these large-company stocks are found in SMI’s stock Categories 1 and 2.

  • Dow Jones Industrial Average (DJIA)
    Although this is the best known of all market indexes (and the one that gets the most attention in news reports), “the Dow” is actually the least useful major index. It measures the performance of only 30 specific companies. While these 30 are selected carefully to reflect the fortunes of the general economy, a sampling of 30 stocks simply can’t be as accurate a barometer as an index that includes hundreds (or thousands) of stocks. Also, the Dow is price-weighted (higher-priced stocks have more influence than lower-priced ones, regardless of market capitalization), hindering its usefulness.
     
  • The Standard & Poor’s 500 Index (S&P 500)
    This index, made up of 500 of the most widely held companies from all the major sectors of the economy, has long been the preferred benchmark of investing pros. Many think of the S&P 500 as the “gold standard” of indexes. With coverage of roughly 80% of the stock market’s value, the S&P 500 is an excellent gauge of large-company stock performance, but not the entire market.
     
  • Russell 1000
    This index, composed of the 1,000 largest companies in the Russell 3000, represents roughly 90% of market capitalization. The Russell 1000 includes many of the medium-sized companies that the S&P 500 does not.

Medium-sized-company indexes

Medium-sized firms sometimes cause confusion for SMI readers because we group these companies together with small-companies (Categories 3 and 4). We do this to gain simplicity for new investors, but it’s good to recognize that these stocks, and the funds that invest in them, often behave differently than their smaller siblings.

  • Standard & Poor’s MidCap 400
    Although this index contains 400 stocks, it represents only about 7% of the market’s overall value due to the step-down in company size. S&P MidCap 400 is the most widely used index for tracking the performance of mid-sized firms.
     
  • Russell Midcap Index
    This index contains roughly 800 of the smaller stocks included in the Russell 1000. In other words, it contains the “smallest of the big” stocks. At about 30% of market capitalization represented, it’s a broader measure than the more narrowly focused S&P 400 index.

Small-company indexes

These indexes fall into two distinct groups: the pure small-cap indexes and what you might call the “small-caps plus” indexes. All three indexes listed below contain a numerical majority of small-company stocks, but the Nasdaq also includes some medium and even large companies. As a result, the Nasdaq Composite offers less of a pure reflection of small-company performance than do the S&P 600 and Russell 2000. For SMI purposes, however, a fund based on any of the indexes below is appropriate for investing the Category 3 or Category 4 portion of your portfolio.

  • Russell 2000
    This index, another subset of the Russell 3000, is generally accepted as the best measure of pure small-company stock performance. The average company included here is worth about $700 million. The Russell 2000 index represents about 8% of total market capitalization.
     
  • Standard and Poor’s SmallCap 600
    Despite covering only 3%-4% of the U.S. stock market in terms of market value, this index is used by several funds as a benchmark for small stocks because of the well-known Standard & Poor’s brand.
     
  • Nasdaq Composite
    Originally started as a place to trade small over-the-counter stocks, the Nasdaq still reflects the fortunes of the roughly 3,000 SMI Category 3 and Category 4 stocks that comprise it — at least to some degree. Beginning with the tech boom of the 1990s, the Nasdaq became synonymous with “technology stocks” because of the emergence of Nasdaq giants such as Apple, Microsoft, Intel, and Cisco. Given the massive sizes of some of these companies and the influence they have on this index, it has become more of an “all-cap” index as opposed to pure small-cap.

International

  • MSCI EAFE
    This index (Morgan Stanley Capital International Europe, Australasia, Far East) covers “developed” foreign markets (as opposed to those considered “emerging”). As a broad foreign index, it does a good job — although some investors complain that by grouping so many geographical areas together, the MSCI EAFE obscures the fact that various international markets perform quite differently at times — e.g., stocks may be tanking in Europe but improving in Asia, or vice versa.

Value/growth subsets

Refinements to many of the above indexes have created additional indexes split into “value” and “growth” components. Such splits usually are accomplished by applying one or more valuation measures to all of the stocks in an index, with those meeting certain criteria being placed in a value index and the rest being put in a growth index.

Because growth/value characterizations allow greater customization, these refined indexes can be useful to SMI readers. For example, when using an index fund based on the entire S&P Small Cap 600 index, you would have to allocate that fund equally to SMI Categories 3 and 4. However, if you have access to an S&P 600 Growth fund and an S&P 600 Value fund (or ETFs of same), you can tailor your purchases to the exact percentage you want in Category 3 (small-value) and Category 4 (small-growth), respectively.

Using this information in your 401(k) plan

Once you understand these various indexes, and identify funds that track them, it’s easy to construct an index-fund portfolio within your 401(k) account. Simply follow our Just-the-Basics formula by dividing the stock portion of your portfolio this way: 40% large-company focused, 40% small-company focused, and 20% international.

Note: Our monthly Fund Performance Rankings don’t list every index fund simply because funds that track the same index perform almost identically. So, when researching index funds in the FPR, use the sample funds in the table below as proxies for the rankings of other funds that are based on the same indexes.