Index Investing is Upwardly Biased

The odds are always stacked in the house's favor. Luckily, you own the house.

If the last decade hasn't tested your belief in the old axiom that "the stock market is a great long-term investment" I am not sure what will. It seems like every time the markets get any momentum behind them something comes along and yanks the rug out from under them and down they go. However, believe it or not this is a good thing for the future. Let me explain why.

S&P Chart.png

S&P 500 Closing Values

Stock market indices like the S&P 500, exhibited above, almost by definition must go up over time.

Why? Because they are structured with a bias to do so. Actually, there two biases at work here that make an upward trend over time a virtual certainty:

  1. Selection Bias - The S&P 500 and the Dow Jones Industrial Average both are selective indexes. This means that they track only a select number of companies. For the S&P it is the "500 leading companies in leading industries of the U.S. economy" whereas the Dow tracks 30 companies that Dow Jones believes "to provide a clear, straightforward view of the stock market and, by extension, the U.S. economy." So what happens when one of the companies included in either of these indexes starts to perform poorly? Or what happens when a company like Google bursts on the scene? You got it, out with the junk and in with the good stuff. As you might imagine investors prefer to put their money in the stocks of companies whom they believe will do well in the future. The more people buy a certain stock the more that stock's price goes up and the better the company performs the more people who own the stock will require in return to part with their shares. If the component company stocks go up in price so will the index at large.
  2. Survivor Bias - A few short years ago General Motors was a component company in both the S&P 500 and the Dow 30. Now, GM is not listed on any index because it is not currently a public company. You won't find Merrill Lynch or Bear Stearns shares weighing down any index either. These companies all died as far as the stock markets are concerned. It's a rather Darwinian survival of the fittest type of environment. Even non-selective indexes like the Wilshire 5,000, which strives to capture a complete picture of the equity market, is biased to track strong performing companies over time. 

Does this mean that stocks are not risky in the long run? No. As Professor Zvi Bodie (I was student of Dr. Bodie's at Boston University) reminds us, the long-term is made up of a series of short-terms. The market can have several bad years in a row, it can stay flat for a decade or more and it can go on phenomenal bull runs as we saw during the 80s and 90s. 

The take away is that index investing does have an upward bias even if that upward movement is not predictable over any one particular time period. However, we can model likely outcomes with different degrees of confidence as a result of what we learn from these biases of the indexes in which we invest.

What are you thoughts? How are you feeling about the future of the markets? How much of your current portfolio is invested in stocks index vehicles?

Mike Langford

Founder & CEO of finservMarketing. Financial services industry veteran with over 20 years of experience in both retail and institutional segments. Early pioneer in the use of social media and digital marketing for financial advisors.