Poll - The Stock Market and Vintage Sales

[Balticfox]

Originally Posted by angolajones

Can you explain this?

I thought someone would ask because very, very few people have thought through the mechanics/mathematics behind indexes.

An index you see doesn't come down from the gods. It's actually a group of stocks selected by a bunch of seasoned elders, i.e. old men, to be representative of the broad market. "Representative" though means average. So first of all this basket of stocks isn't selected to outperform. It's not about outperformance; it's about being average.

Secondly consider the stocks that make it into the index. They are those of companies that have grown to the point where they've become "established". Be nice of course if you as an investor were into these stocks as the companies were growing to the point of becoming established.

It gets worse though. If and when these stocks continue to grow in value for whatever reason, their weight in the index increases. As a holder in the index, you are therefore increasing the percentage of your "portfolio" in stocks that have already grown. You're thus buying high or at least prevented from selling high.

And when are stocks removed from the index? When the underlying companies fall upon hard times and are at death's door. Those stocks are then removed because they're no longer "representative". So as an index holder you sell those stocks at a low after riding them all the way down. Wouldn't it have been much nicer though if those stocks had been removed when they were high priced?

The most notorious example of this phenomenon was Canada's own Nortel. At its peak in 2000, Nortel represented over 35% of the value of the TSE300. The stock was removed from the index when it was down to pennies. A TSX index investor therefore automatically rode the thing all the way down!

[Peter_Spaeth]

Originally Posted by Balticfox

I thought someone would ask because very, very few people have thought through the mechanics/mathematics behind indexes.

An index you see doesn't come down from the gods. It's actually a group of stocks selected by a bunch of seasoned elders, i.e. old men, to be representative of the broad market. "Represent ative" though means average. So first of all this basket of stocks isn't selected to outperform. It's not about outperformance; it's about being average.

Secondly consider the stocks that make it into the index. They are those of companies that have grown to the point where they've become "established". Be nice of course if you as an investor were into these stocks as the companies were growing to the point of becoming established.

It gets worse though. If and when these stocks continue to grow in value for whatever reason, their weight in the index increases. As a holder in the index, you are therefore increasing the percentage of your "portfolio" in stocks that have already grown. You're thus buying high.

And when are stocks removed from the index? When the underlying companies fall upon hard times and are at death's door. Those stocks are then removed because they're no longer "representative". So as an index holder you sell those stocks at a low after riding them all the way down. Wouldn't it have been much nicer though if those stocks had been removed when they were high priced?



The most notorious example of this phenomenon was Canada's own Nortel. At its peak in 2000, Nortel represented over 35% of the value of the TSE300. The stock was removed from the index when ii was down to pennies. A TSX index investor therefore automatically ode the thing all the way down.

I thought SPY, Vanguard 500, etc. are weighted.

[Balticfox]

They are weighted. This means the higher the market capitalization of the company, the greater its weight in the index. So as the stock increases in price (in a vacuum), as an index investor the percentage of one's portfolio in that one stock increases.

[Peter_Spaeth]

Originally Posted by Balticfox

They are weighted. This means the higher the market capitalization of the company, the greater its weight in the index. So as the stock increases in price (in a vacuum), as an index investor the percentage of one's portfolio in that one stock increases.

I used the term wrong but in any event thank you for the explanation. Are there any index funds that seek to maintain an equal percentage of each holding, and adjust as they fluctuate?

[raulus]

Originally Posted by Peter_Spaeth

I used the term wrong but in any event thank you for the explanation. Are there any index funds that seek to maintain an equal percentage of each holding, and adjust as they fluctuate?

Yes. There’s an equal weighted S&P 500, for example.

[Gorditadogg]

Originally Posted by Balticfox

I thought someone would ask because very, very few people have thought through the mechanics/mathematics behind indexes.

An index you see doesn't come down from the gods. It's actually a group of stocks selected by a bunch of seasoned elders, i.e. old men, to be representative of the broad market. "Represent ative" though means average. So first of all this basket of stocks isn't selected to outperform. It's not about outperformance; it's about being average.

Secondly consider the stocks that make it into the index. They are those of companies that have grown to the point where they've become "established". Be nice of course if you as an investor were into these stocks as the companies were growing to the point of becoming established.

It gets worse though. If and when these stocks continue to grow in value for whatever reason, their weight in the index increases. As a holder in the index, you are therefore increasing the percentage of your "portfolio" in stocks that have already grown. You're thus buying high or at least prevented from selling high.

And when are stocks removed from the index? When the underlying companies fall upon hard times and are at death's door. Those stocks are then removed because they're no longer "representative". So as an index holder you sell those stocks at a low after riding them all the way down. Wouldn't it have been much nicer though if those stocks had been removed when they were high priced?

The most notorious example of this phenomenon was Canada's own Nortel. At its peak in 2000, Nortel represented over 35% of the value of the TSE300. The stock was removed from the index when it was down to pennies. A TSX index investor therefore automatically rode the thing all the way down.

That's a good explanation Vai. When you own an index fund, you are buying after everyone else is buying and selling after everyone else is selling.

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