Distorting indexes

The S&P 500 and Dow may not be a good benchmark esp. for long term (say 15 years) for the following reasons. It would give you distorted results if it is not used correctly. The better ones are the equivalent ETFs but they have a shorter history like SPY.

1. Survivorship bias. If you do not include Lehman, AIG..., you will have better return for dividend stocks. How many dividends you have to gain when you lose the entire investment on these stocks?

2. Most companies in the 1920s have not survived. They may spin off, being acquired, change name... Examples abound. Comparing the index for a specific year is fine but not from 1920 to today.

To illustrate, a spun off company originally worth $100 is spun off to two companies with $50 each. It does not mean it loses half of the value and the data base should adjust the price accordingly.

3. When I use a database with no survivorship adjustments, I usually have screens making incredible returns especially those screens with no selection on stock price.

To illustrate, I have two stocks costing one cent each. One goes to 2 cents and hence makes 100% return and the other one goes to 0. In reality, my return is 0. However, the database does not include the bankrupt stock and hence it shows me I have a 100% gain.

When you see the ads claiming of unbelievable returns, it could be the survival bias or they use the best price of the day to their advantage.

4. Stocks are added and removed from the indexes every year. The ones that are removed could be bankrupt or doing badly like Kodak, Polaroid, AIG, Bear Stern... It would make the indexes look better than they really are.

5. Inflation. When I was in college, I paid $1 for a Value Meal and now I need to pay $7. My stock has to make seven times to break even, not to mention the taxes Uncle Sam and the state get from me.

6. Dividends are not added to the index. When your investment says they have 10% return and compared it to the index with 8%, the comparison could be misleading. The investment by law can include dividend while the index is usually not.

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Investment decisions are educated guesses based on current market conditions, tax laws... A lot of time indexes cheat and you need to adjust your result accordingly.

I prefer to use S&P 500 (^SP500 in Yahoo!Finance which has historical data) for its diversity: 1. 500 is more diversified than Dow's 30, and 2. value-weighted (vs price-weighted).

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(c) TonyP4 2012. Written in 3/29/12. Last updated in 5/2/12.

Disclaimer:

Do not gamble your money you cannot afford to lose. Past performance is a guideline and does not guarantee future performance.

All my posts are for informational purposes only. I'm not a professional investment counselor. Seek one before you make any investment decision.