Why Indexing Beats the Indexes

Last Updated Jan 5, 2011 11:31 AM EST

This title might appear like a contradiction. Actually, it's absolutely true, and serves to illustrate an important point of investing. We'll examine the Associated Press' take on the 2010 stock market and then compare it to one broad US stock index fund - the Vanguard Total Stock Index Fund (VTSAX).

AP's take on the 2010 US stock market
On December 31st, the AP wrote their annual story of stock market performance entitled - For Investors, A Gut-Wrenching 2010 Ended Well. They noted the following performance:

For the year, each index returned double-digit gains. Over the course of 2010:
--The Dow gained 1,149.46 points, or 11 percent. With dividends, its total return rose to 13.99 percent.
--The S&P 500 index gained 142.54 points, or 12.8 percent. Including dividends, its total return came to 15.1 percent.
-- And the Nasdaq index gained 383.72, or 16.9 percent, to close at 2,652.87. After dividends, its total return came to 18 percent.
How an index fund beat these indexes
The Vanguard Total Stock Index Fund turned in a 17.3 percent return, besting all of the indexes quoted by the AP except the total return of the very narrowly focused Nasdaq. How can this be?

Well, the Dow contains only 30 stocks, and even the S&P 500 leaves out thousands of stocks that represent roughly 30% of the value of the US stock market. Those small and mid-cap stocks were the stars of 2010 and typically outperform the less risky S&P 500 stocks.

Thus, the Vanguard index fund beat the S&P 500 index as reported by the AP by 4.5 percentage points. Even with dividend reinvestment, it still bested the total return of the S&P 500 by 2.2 percentage points.

Why the AP thinks raw returns stripped of dividends is anything other than an inaccurate, biased distortion to mislead investors is beyond me. I'd like to think that my years of relentless hounding may have played some part in them now including the total return of their usual narrow indexes. While that's a start, I'd give the results of my efforts a "D-," as being less misleading is setting the bar far too low. I'm sure Wall Street would award the AP an "A+."

Lessons learned
Much of Wall Street loves the AP standard of reporting the raw indexes. It provides a benchmark that is the key ingredient in crafting the illusion of beating the market. But even using this logic, the only way to assure beating the index is to own the lowest cost index fund. That way, you get the index return plus dividends.

As Mint.com writer Matthew Amster-Bruton put it, "Literally anyone can consistently beat the S&P 500. Just buy a low-cost S&P 500 index fund (such as SPY) and reinvest dividends. You'll get all the returns of the S&P minus a tiny fee, plus the dividends."
So there you have it - indexing beats the index every time. I guess the AP would consider me an active investor. Who knew?

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.

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