Monday, October 26, 2009

Stock Market Index is a Phony: Why an Investment Strategy Usually Flops

A striking feature of the financial forum is the inability of the average investor to iron out an investment strategy that can keep up with the stock market index of choice. Although the reasons for the failure are multiplex, we will focus here on one factor that has escaped public scrutiny thus far: the benchmark is not what it seems.

According to common perception, a market index is a neutral yardstick that measures the performance of the bourse as a whole. In truth, though, the popular view happens to be wrong.

Admittedly, the image of the benchmark could agree with the reality in certain cases on certain occasions. As an example, the average price for the entire ensemble of stocks in a particular industry could be a trusty measure of the market segment over the course of a few moments or even the span of several months.

On the other hand, none of the benchmarks used by the financial community provides an accurate view of the market as a whole over longer periods. This shortfall lies at the root of the curio in which the average investor cannot keep up with the market averages.

Mistaken Identity

In the eyes of the general public as well as the financial media, a benchmark is a representative gauge of the behavior of the overall market. This perception is illustrated by the usual description of an index fund designed to match the performance of a benchmark. In particular, a pool of this sort is presented as a passive vehicle as if it requires no intervention by the custodians.

In reality, though, the popular viewpoint stems from a misconception of the nature of a benchmark. To begin with, a market index is rarely – if ever – an index of the entire marketplace. Rather, the yardstick is wont to tally only the stalwarts in the forum.

As an example, the Dow Jones Industrial Average covers just 30 of the largest and stoutest firms in the arena. Meanwhile, the popular version of the S&P index used by the financial community contains merely 500 of the biggest firms listed on the bourse.

Given this backdrop, the term “market index” is in fact a misnomer. Instead, an alternative moniker such as “elite index” would be more in tune with the reality.

On one hand, the number of stocks covered by a benchmark is apt to remain fixed over time. On the other hand, the names on the roll call come and go in line with their performance in the forum.

For this reason, the benchmark today is not the same object that it was in the past. To say that one batch of players is identical to another simply because the two sets happen to contain the same number of members is a sheer flight of fancy.

To underscore this point, we will take up a simple example from everyday life. In the process, we will show how the same logic could be applied to a bunch of groceries to come up with ludicrous results.

Fruits Can Outrun Stocks

For our showcase, we will consider a basket containing a dozen vegetables. Suppose that the batch has a combined value of $1.20. In that case, the average price of the vittles comes out to 10 cents. Based on the latter figure, we will assign the value of 10 points to denote the level of the price index for the entire basket.

As the days go by, the veggies in the basket will begin to wilt and shrivel. Whenever an item in the batch has passed its peak of freshness, it is thrown out and replaced by a brand-new selection from the grocery store.

As an example, a mushy tomato might make way for a green banana of equal value. In a similar way, a bag of peas could be switched out for a bunch of grapes.

With the passage of time, one after another of the original set of vittles is discarded and replaced by an up-and-coming piece of fruit. After a week or two, none of the initial goods remains in the basket. Rather, the whole batch ends up consisting entirely of fruits at varying degrees of freshness.

In addition, the new entrants gain in value as they ripen over time. As a result, the basket rises in value to $2.40 as the days go by. In other words, the average price of the vittles comes out to 20 cents. In that case, the index of the basket turns out to be 20 points.

Put another way, the value of the basket has doubled in value within a couple of weeks! Holy cow – everyone ought to load up on groceries as a way to boost their wealth.

If the mass media and the general public were to use the same approach in dealing with the bundle of groceries as they do with a basket of stocks, they would go wild with excitement. Groceries have doubled in value within a couple of weeks! Buy food now!!  Get rich QUICK!!!  The road to wealth leads to your grocery store….

Crux of a Stock Market Index

A benchmark of the bourse is propelled upward by an endless stream of sturdy stocks. Like a relay race, a sprightly entrant takes over the baton each time a spent player drops out of the running.

In this way, the yardstick rides on a constant stream of newfound energy. In fact, the benchmark is designed to represent the combined strength of the stalwarts in the prime of their lives. For this reason, the conventional yardsticks of the forum do not come close to reflecting the fortunes of the entire field of stocks.

In this milieu, the only way that the investor can match the performance of the index is to replicate the process in toto. In particular, the gamer has to resort to the same scheme of endless renewal of stocks in the portfolio.

On the other hand, the majority of investors have neither the time nor the desire to keep tabs on the bourse without letup. Nor do they have the patience to figure out whether a downstroke for each stock is just a temporary setback or the first step in a secular decline. In addition, most folks have neither the training nor inclination to do a thorough job of scouring the entire population of stocks in order to pick out the most promising candidates to serve as replacements for the washouts in the portfolio.

Losers Galore

Against this backdrop, it's not surprising that the majority of individual investors and commercial outfits are unable to keep up with the market benchmarks. The investment vehicles in this predicament include mutual funds as well as hedge funds.

If full-time professionals on average lack the savvy to keep up with a stock market index, what hope is there for part-time investors? It’s no wonder that the average investor lags the market benchmarks.

All that is the bad news. Amid the thicket of gloom and doom, though, there is a sliver of light and cheer.

Keeping up with a Stock Market Index

On the upside, there are straightforward ways to match the performance of a market benchmark. The simplest of these schemes is to buy a batch of shares in an index fund designed for the purpose.

Granted, the ability of an index fund to keep up with the target yardstick might not be perfect. One reason for the discrepancy stems from the administrative cost of running the pool. However, the usual fee each year is only a small fraction of 1% of the total value of assets under management.

In that case, an index fund should be able to match the course of the benchmark within a nominal fraction of a single percent. The level of performance is wont to be good enough for all practical purposes.

Roundup for Investment Strategy

To sum up, a benchmark of the stock market is presented as if it represents the bourse as a whole. In practice, however, the yardstick does not cover the entire field of stocks.

In addition, the index is a cagey structure that flits from one set of stocks to another depending on the vicissitudes of the marketplace. More precisely, the custodians of the benchmark throw out the laggards and replace them with pacers on a continual basis. For this reason, a telling term for a market yardstick would an “elite index. Moreover, the performance of the team is driven by a relay race rather than a fixed group of stocks.

One of the wacky consequences of the biased scheme is the propensity of a benchmark to clamber upward regardless of the behavior of the market in general. The positive bent comes from the practice of switching out the deadbeats with the upstarts on the ascendant.

As a result, the yardstick is apt to rise even if the market as a whole happens to go nowhere. In fact, the benchmark could advance at times even if the bourse at large were to decline.

The situation is analogous to a bundle of veggies whose value keeps growing indefinitely. Even if the cost of groceries happens to remain stable, the continual replenishment of vittles as they ripen and gain in value could drive up the price of the basket over time.

In this setting, it’s hardly surprising that the vast majority of players in the forum are unable to keep up with the benchmarks of the bourse. Pratfall is the norm whether the participants happen to be part-time amateurs or full-time pros.

In spite of the dismal news from the financial front, though, there is a simple fix to the stumper for legions of gamers who want to get out of the rut. By turning to an index fund, an investor can largely keep up with a target benchmark and thereby beat out the bulk of contenders in the arena.

To top it off, the wily player can attain the uncommon feat of matching the benchmark without spending any time or effort in updating the portfolio or even keeping tabs on the marketplace. For the vast majority of investors, the best approach to investment strategy is as simple as can be: buying into a fund designed to keep up with a stock market index.