What Is Indexing and How Is It Used Across Various Areas?

By Indeed Editorial Team

Published May 29, 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Indexing data creates a baseline and a reference point for comparing financial information. Using an index allows you to monitor the economy's relative value and compare the data irrespective of any major differences in scale. Learning what indexing is and understanding the importance of indexes can help you make informed decisions when investing, paying taxes, or purchasing real estate. In this article, we answer "What is indexing?", explain the value of an index, explore using indexing to track economic trends, identify factors for compiling retail price index, examine indexing in government programs and private markets, and answer some FAQs.

What is indexing?

To answer the question, "What is indexing?" it's important to analyze the functions of data indexing in economics and finance. Data indexing refers to using available financial information as a statistical measure for monitoring economic data, such as unemployment rate, inflation rate, level of productivity, gross domestic product growth, and market returns.

An index creates a framework specifying the parameters and the timeline for comparing data. It allows individuals to spot trends over time, understand their importance, and compare relative values. This can include the value of the nation's currency, the rate of inflation, or the value of a property.

Related: How to Calculate Inflation Rate (With Examples)

What is the value of an index?

Some indexes allow you to compare different datasets even if there's a vast difference in the magnitude of the different sets. For example, it may not be easy to compare the data between a city with 10 million people and a town with 1 million people. Superficially, the data may show that the larger city has more value because it's significantly larger than the small town.

Indexes help consider the scale differences between both entities. Suppose the value of the larger city is 10,000 people and the smaller town has a value of 1,000 people. You can track the growth rate of both entities relative to their size and get more useful results.

Using indexing to track economic trends

Creating indexes for financial issues helps set a uniform comparison baseline. For example, you can use the consumer price index (CPI) as an index to monitor the currency's relative value. On surface value, $1,000 remains $1,000, but economically, the purchasing power of $1,000 constantly changes due to inflation. Inflation causes the price of products and services to rise over time, reducing the value that $1,000 offers you constantly. The CPI index helps economists identify if inflation is rising, the current market trends, and the relative increase or decrease in real wages.

The CPI index has different applications. For example, it may influence how much raise a person may get. This is because some companies may use it as a criterion for determining annual raises to ensure that the relative value of the employees' salary remains constant or increases. When labour or employee unions negotiate salaries and contracts, they may also include an annual cost-of-living wage adjustment clause as a part of the contracts.

Related: 17 Jobs in Economics (With Salary and Job Expectations)

Factors for compiling retail price index

These factors may affect how economists can measure the average change in the prices of goods and services every month. The factors for compiling the retail price index include:

Section of the population

Choosing the relevant section of the population depends on what you want to use the index to calculate. For example, if you want to regulate pensions for retired workers, the relevant section of the population is the older adults. Similarly, if you want to find the level of economic development of a city, it's essential to collect data from all classes of people. It's advisable to exclude people on the extremes of the economic spectrum because including them may distort the data.

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Average pattern of expenditure

You can find the average expenditure by conducting a survey of families' expenditure in the select group. For the data to remain authentic, it's essential for a random group of families to provide their expenditure details on random dates throughout the year. After gathering the data, you can calculate the average expenditure pattern of the group.

Index's base year

When selecting the index's base year, it's important for you to select normal years. It's advisable to avoid exceptional years such as periods of emergency, political disruptions, and pandemics. The reason for this exception is some factors influencing the prices may not be relevant in the future.

Indexing in government programs and private markets

Governments, corporations, investors, and individuals may use indexes or indicators for different purposes. These may include:

Government programs

The government indexes most of its programs to track inflation properly. For instance, they may increase social security payments due to an increase in the cost of living. There's a cap on the maximum income level social security taxes because of a rise in inflation. For example, two legal instruments regulate the public service pension plan benefits indexing. Typically, the government calculates the increases in pensions using the annual consumer price index.

Investment markets

The S&P Dow Jones Indices is an example of investment indexes. The S&P Dow Jones indices partnered with the Toronto Stock Exchange (TMX) to create a reliable benchmark for market performance. This composite index is a capitalization-weighted equity index for tracking the performance of the largest organizations listed on the primary exchange market, the Toronto Stock Exchange (TSX). This index is the equivalent of the American S&P 500 index and functions as the major indicator of the economy's health.

The Standard and Poor (S&P) calculate this index, and the largest S&P/TSX index contains up to 230 publicly traded companies. Larger companies heavily influence the S&P/TSX index because it adopts the market capitalization approach to calculate indices. As the nation's benchmark index, the S&P/TSX index performs functions such as providing an understandable overview of public companies' performance. It can also provide a standard for fund managers to compare results and a defined structure for index funds and exchange-traded funds to follow.

Related: How to Get Into Investment Banking in Canada: A Guide

Frequently asked questions about indexing

Here are some frequently asked questions related to indexing:

What is an index number?

In statistics, index number refers to the measurement of change in variables over a particular period. It typically shows the general relative change instead of measurable figures. You can express index numbers in percentages.

What are the types of index numbers?

These data figures usually reflect a price compared with standard values. These standard values often equal 100 points. The major types of index numbers are:

  • Value index: You can get the value index number from the ratio of a particular period's aggregate value and the base period's aggregate value. This value is useful when tracking foreign trade, sales, and inventories.

  • Quantity index: The quantity index number helps monitor changes in the number of goods produced, sold, and consumed in a particular period. An example of a quantity index is the index of industrial production (IIP).

  • Price index: The price index number helps measure price changes over a period. Examples of price indexes include the wholesale price index (WPI) and consumer price index (CPI).

What is direct indexing?

Direct indexing refers to the index investing approach that involves purchasing individual stocks in an index in the same weights as the index. It's the opposite of purchasing an index exchange-traded fund or index mutual fund that tracks indexes. This process provides better tax advantages, control, and autonomy to investors.

What is index investing?

In passive investing, known as index investing, an individual makes investments based on the benchmark index. Investments rise or fall with the specified index. This kind of investment is passive because they aren't making transactions or decisions. Instead, they allow the index value to determine if the investment succeeds or fails. Index investing offers multiple advantages, such as low costs, as it attracts lower management fees compared to active investing due to its passive approach.

As index investing doesn't require them to build their portfolio, it also makes it an easier investment path. Index funds grant an investor access to various stocks that may be difficult to replicate at an individual level. Having access to different stock options helps diversify their portfolio and protects them from industry-specific risk. Regardless, index investing lacks downside protection, as it doesn't have a minimum loss amount. Investors can choose the composition of their index funds or remove and add any holdings.

What is the difference between active investing and index investing?

In active investing, investors and financial managers apply their skills to attempt to outperform the total market average. Typically, they aim to identify stocks with high growth potential in the long term. This investing attracts higher transaction costs and management fees because the portfolio changes frequently compared with index investing. Some factors, such as market uncertainties and the investor's biases, may influence this investing.

Actively managed portfolios may contain more diverse holdings than index-based portfolios. The financial manager may invest in international stocks, domestic stocks, and other assets apart from equities. Conversely, index-based portfolios contain only domestic equities. The holdings aim to mirror the underlying baseline index. The portfolio may change only when the baseline index changes.

Please note that none of the companies, institutions, or organizations mentioned in this article are affiliated with Indeed.

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