How Stock Market Indices Underperform

One frequent complaint made about stock-market indices is that they’re not truly representative of the stock market as a whole, since they exhibit what’s known as “survivorship bias”. If a company is failing it drops out of the index, to be replaced by a more successful firm. In turn, that should boost the index’s return, right?

Wrong. It’s wrong for the S&P 500, and, says Henry Blodget, quoting John Mauldin, it’s wrong for the Dow, too:

If Dow Jones hadn’t tinkered with the index, the 30 companies would have merged or failed their way down to just 9 survivors. Of the 21 companies in the original 30 that are now gone, 20 disappeared through M&A, some were replaced by successor firms and others not, and only one (Bethlehem Steel) failed outright.

But this no-fiddling index would have topped out at just over 30,000 in October 2007 and would have finished 2008 at 14,600…

With the Dow 30, your $100 would have grown to $96,993 as of December 2008, but the Original 30 would have grown to $161,603…

[T]here is an even bigger differential if you simply equal-weight the components rather than use a price-weighting methodology. Your $100 grows at a 10.4% clip and becomes $272,554, or almost three times the actual Dow 30.

Maybe this is the best possible reason for not investing in index funds: indexes underperform. Instead, just pick a basket of stocks, and hold them forever, reinvesting dividends. Some will go to zero. But you’ll still be significantly better off than holding the index, assuming you can reinvest dividends cost-free.