The long-term performance of stock indices is often given to "prove" that stock market investments are one of the best investment options. But are the decks stacked?
When an index is created, only relatively solid stocks of a certain economic weight are selected. More risky stocks are put aside - at least until they become less risky.
Later, other solid growth stocks are added at a moment when they are perceived to be on an upward turn, for example, the addition of Microsoft to many indices.
Other stocks that were in the index are dropped, always when they are on a downward turn. But they are almost always dropped before they go bankrupt or turn into penny stocks - thus saving the index from economic reality.
Doesn't this mean that AVERAGE investor return is ALWAYS significantly WORSE than the indices would suggest?
Is there any research that quantifies this difference? Thank you for the answers already received.
What I am trying to understand is if statistices on long-term investment are reliable. The price of gold, for example, is very straight-forward. The value of real estate is somewhat more complicated, but since the land itself is a constant (unlike the stock portfolios included in indices), it also seems more straightforward.
The statistics given to support the stock market as an investment tool are always the indices. And yet, the Dow Jones, which because it has existed so long, is the index most used to demonstrate the level of the rise in stock prices, has thrown out one half of its basket in the last 20 years. What happened to those once-important stocks? A few ceased to exist because companies were sold or consolidated. But many were removed, supposedly because they "represented the market" less well than than other stocks. But the removed stocks are almost always companies in trouble, while the new stocks are almost always winners. Actually, you do have a valid point. In fact the indices are biased toward a optimistic reading of market performance. The Dow is actively managed to "more accurately reflect modern investment trends". That is the poorer performers are replaced with better performers. And the S&P 500 is continually reconstituted to reflect market capitalization. That is those stocks that go up in price are given a greater weighting than those that go down in price. Interestingly, there is an equal weighting index fund based on the S&P 500 stocks with the ticker RSP. And this index fund outperformed the cap weighted S&P 500 in 2005 and 2006 by a significant amount. This year it is underperforming the S&P 500.
There are other indices that also have outperformed the S&P 500 during the past several years. The Russel 2000 a small cap index outperformed the S&P 500 in 2001, 2002, 2003, 2004, 2006. It underperformed in 2005 and 2007. So despite the the attempts to enhance index performance, it does not always work as intended. Invest in an index fund and you will alway get what you consider a false positive.
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You know, your logic to this doesn't make sense. You don't buy (let's use the DOW) the dow today and hold it forever. Indices are not set up for the purpose of proving the stock market is a better investment, than let's say gold or land. It's not even set up to see how the economy is going. There has been times that the economy sucked, jobs were hard to find and the DOW was going good. It's set up to tell you if you should be in the market or out of the market. And not, "Should you be in the market for 30 years."
I owned one company that went from $5.00 to over $150.00 in about 8 years. It was never on the DOW. But it was a better investment than anything on the DOW. It was also gambling as it was a small cap stock. No matter how far the DOW falls, someone is going to make a profit buying long. No matter how far the DOW goes up someone is going to lose their shirt buying long.
So you own a stock, whether on the DOW or not and it keeps dropping, but the DOW keeps going up. That tells you something. Now, let's say you own the same stock and the DOW consists of all the old famous Steel companies of the past. What use would it be to you?
I think you have it in your head that the indices are a sales or promotion claim for the stock market. It's not... it is a tool for stock investors. Stock market indexes are designed to provide a picture of the market's performance, and not to offer an overly optimistic view. The stocks selected for the index are those that are considered to be representative of the market. thus the Dow Jones indexes focus on strong industrial, transportation, and utility stocks, and these indexes are indicative of the performance that can be expected by an investor who selects a well balanced portfolio of those stocks.
There is no point in including in an index stocks of companies that are untested, inexperienced, overly risky, and weak. They are not representative of the market in which most people wish to invest. Specialized indexes exist however, such as small cap stocks, those that have small capitalizations, tech stocks, and others.
If by average investor you mean someone who selects stocks at random, and may wind up with a lot of marginal stocks not included in indexes, it is possible that investor will not do as well as the index. But average investors are more knowledgeable and tend to be selective and indexes can help them compare their performance. I think your observations about the practice of adding the winners and dropping the losers are factual for all representation indices. It has the practical reason of maximizing the utility of the index: the representative stocks should be the ones more people care more about. The representation indexing practice was historically rooted and should have been abandoned given today鈥檚 digital computing powers which could instantly complete any population index.
Your conclusion, however, is bearishly biased. The average investor is the average of the investors who are both the winners and the losers. For a fixed-count index, for each declining stock to be deleted there is an advancing stock to be added. Investors who own the dropped stock lost money; but those who owns the added stock made lot of it. So the population-averaged return should not be too far off from the index. Your question doesn't make any sense. An index is just a figure that tracks the performance of its underlying constituents. The end.
You set up your parameters for your index and you then have to include and track all the instruments that comly with your parameters. If a particular instrument ceases to comply than you take it out of the index.
You mention that the index only includes solid growth stocks. Where do you get this from?
I think you are looking at this the wrong way round. The index constituents must be looked at first. If you are worried about not being able to do as good as the index's, why dont you invest in the index's?
Example: SPY=S&P 500
I have beat the market and I have lost money in the markets. This year I lost, but thats because I bought shares on Margin(borrow money) and bought risky stuff. Take the S&P 500. S&P spends a great deal of time evaluating stocks, and this index is supposed to represent their opinion of the 500 best US stock from upper mid-cap to mega-cap in size.
If you think they do a fabulous job at this, then buy the index in the form of the ETF SPY or IVV. I do, even though I appreciate that it may not be a perfect index.
Does it represent the entire US stock market? Of course not. It makes no attempt to include small or micro cap stocks which can be hugely important in a good portfolio. But it doesn't try to either.
The DJIA index is even worse, in that it includes mega-cap stocks only. Why have the DJIA? Because historically, rich people would invest by buying portions or all of the stocks in the DJIA. Not because it was necessarily the best method, but because it was considered safer than most, with decent returns.
While your point doesn't quite make sense as an investment question, it is interesting as a whole market comment in 2007. As an investment question, the problem is that investors don't spend time thinking about how to make poor investments, only good ones. So why worry about the obvious losers? (Which losers are the obvious ones??)
However, since the S&P 500 is market cap weighted, it's performance is dominated by the 30 largest companies in it. In 2007 there are at least a couple dozen stocks in the S&P index that had massive declines, even though the index did OK. Remember that all of the 500 are supposed to be pretty good. It is a signature year, in the sense that a surprising number of these stocks performed unbelievably badly. As much as I wanted to not answer your question it just proved too tempting to pass up.
Your argument makes some very good points, but it also depends on the index. Your example cites the DJIA, it is an arbitrary 30 "industrial" stocks. These stocks are picked to be "representative" of the US stock market. The reason this index is so widely quoted it that it was the first stock index and the average person has heard of it. The media plays to the masses, even if there are better alternatives. There are some serious flaws in the way the DJIA is put together in my opinion. My list of gripes are, that it is only 30 stocks, it is too focused (not enough variety), stock are picked arbitrarily, and it is price weighted not market cap weighted. This is why I like to look at the S&P 500 or Russell 1000.
Both the R1000 and S&P 500 have a strict set of rules for what stocks are in the index. For example S&P 500, is the 500 largest (by market cap) and must have at least 50% of outstanding shares in the float. Stocks are not arbitrarily added or removed like the DJIA, they are only added or removed based on meeting the indices requirements. So, not all indices are created out of solid or quality stocks to begin with, the S&P 500 contains "good" and "bad" stocks. More risky stocks are not set aside, if they meet the basic requirements they are added.
I disagree with your statement about bad stocks being dropped, saving the index from economic reality. If a stock goes from $90 down to $15 while in the index, the majority of the decline happens before it becomes a penny stock or goes bankrupt, and therefore before it is removed, so it does not save the index from suffering a decline until it is removed. In fact the majority of the decline may happen while it is still in the index; it must be kept until it no longer meets the requirements of an index such as the S&P 500 or R1000. This may not happen much in the DJIA but can frequently happen in the S&P 500 or R1000.
Your assumption the "the AVERAGE investor return is ALWAYS significantly worse that the indices would suggest" assumes that an investor can never sell out of their position, and must hold it throughout the decline. This is not true, in fact the average investor may have a higher degree of ability to sell a loser than an index like the S&P 500 and R1000, as the index must hold the stock if it meets the indices criteria. This also assumes that the creator of the index "knows" which stocks will be "bad" or "good" over the next several years and loads the deck accordingly. I don鈥檛 think they know any more about what stocks will be the best over the coming time period any more than anyone else. If it were that easy we would all be rich.
An index must be able to change over time because of merger, acquisition, new companies, and bankruptcy. This must be handled in some fashion, some stocks are dropped others are added. Stocks come and go, that is and always will be part of the market. However, this does not affect most stocks in an index on any given year. I feel that there are flaws but not nearly enough to warrant throwing out the whole index system, and labeling it inaccurate. I believe the good vastly outweigh the bad. Overtime the ways indices are created have changed to more accurately represent the market. Keep in mind that there are many smart people working in the financial world, if it did not track the market accurately one would be created that did. The concept of free markets and the best idea winning out works in the stock market index arena as well. I think indices such as the S&P 500 and R1000 do a good overall job of representing the market. So, I think that the historic numbers for these indices do accurately represent the "market return" over time. |
