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.