However there are other ways of weighting indices: stocks can be weighed by price, the index provider's opinion of the stock's importance, or pretty much any other quantifiable value you can imagine. With the technology available today, some indices have taken to using very complex calculations in determining their value. The S&P 500, for example, is a float-weighted index, which means that the number of shares available to the public are considered in calculating the S&P 500's value.

Charles Dow probably couldn't have imagined using float to calculate an index when he created the first index in 1896. Dow was a founder of The Wall Street Journal, and created the Dow Jones Industrial Average(DJIA or "Dow") as a way to quickly gauge changes in the market. Today, the DJIA is one of a number of prestigious indices that include the likes of the S&P 500.

Though anyone can create an index, only those made and maintained by a select few are given any notice. Standard & Poor's (S&P), Dow Jones & Company, Russell Investments (see Russell 2000), and Morgan Stanley (see MSCI Indices) are a few examples of well-known firms that provide indices.

Risks of Index Funds

How can the SPY trail the S&P at all? Shouldn't it be an exact mirror? While the assets in SPY's portfolio exactly match the structure of the S&P 500, market forces can push an index-tracking ETF price to a premium or discount. Market sentiment adds a little more volatility to these kinds of index funds because it can be reflected by the fund's price before changes occur in the market as a whole (if they do at all).

Besides the risk that an index fund isn't accurately following the index it tracks, another concern is that it will follow the index too closely. While it's definitely possible to make money in a bear market, good luck doing that if you're tied to a big index like the S&P or the Dow. Investing in index funds, especially big ones, can take away some of the maneuverability you have as an individual investor.

Index funds are popular because they're essentially a snapshot of how a particular market, sector, or group of companies is behaving at any given time. And while index funds don't come without a couple of detractors, the bottom line is this: If you're looking for a solid passive investment, an index fund just might be the answer.

Next: Define Your Stock Market Index