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I'm reading this article, which makes the following claim:

In 1974 the Dow closed at 616*. At the end of 2014 it was 17,823*. Over that 40 year period (January 1975 – January 2015) the S&P 500 (a broader and more telling index) grew at an annualized rate of 11.9%** If you had invested $1,000 then it would have grown to $89,790*** as 2015 dawned.

*https://www.mdleasing.com/djia-close.htm **http://dqydj.net/sp-500-return-calculator/ ***http://dqydj.net/sp-500-dividend-reinvestment-and-periodic-investment-calculator/

I'm not specifically concerned with the third claim ("If you had invested $1,000..."), or with any of the advice the author gives, but with the following:

As far as I'm aware, both of these indices grow when the average price for a constant portion of a company in the index grows. However, when a company fails and goes bankrupt, it will be removed from the index. This suggests to me that it is no wonder that the Dow Jones or the S&P 500 always does well: The companies that fail get removed, and stop influencing the average worth.

But doesn't this also mean that the fact that the performance of the Dow always is good (in the long term) doesn't straightforwardly mean that investing in a fund that follows the Dow Jones is always good, since the risk of failure isn't reflected in the value of the Dow Jones?

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    In fact, there are a few downtrends of S&P 500. Removal of a few failed company from the index will not change the index much as long as they do not create a domino financial effect. E.g. like the dotcom bubbles , subprime loan crisis. – mootmoot Sep 4 at 11:14
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    Companies that become bankrupt are removed from the index long before they become bankrupt. Also, it is bonds that default, not companies. This is a stock index, thus I changed the question title. – Ellie Kesselman Sep 5 at 12:25
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Companies move in and out of the index for multiple reasons. Some fail, some split, some merge, some are bought, some change so they no longer qualify. The team that creates and maintains the index determines what companies qualify, and then slowly makes changes as conditions change.

For the individual investor the selection of a fund that follows the index means that they will not have to pay directly for a team to evaluate which stocks to invest in. The fund just follows the direction of the index definer.

To be an index the components must change slowly, otherwise the fee for selling stocks that are kicked out of the index and buying the new components would significantly impact the returns, and can impact the tax efficiency. The index definer doesn't just tweak the contents to make the index perform well, the goal is to serve as a benchmark for some market.

The need for the fund to be tax and fee efficient will cause some funds to lag the changes to the index to manage the costs and taxes. The index definer will also minimize the changes by sometimes allowing the number of companies to be slightly larger or smaller. If two companies in the S&P 500 merge they will not immediately pick a replacement, they may wait a while until they are ready to make other changes.

The reason why the S&P 500 index is popular, is that it is broad enough to serve as a benchmark for the entire US focused market. It doesn't always do well. It has down days, weeks, months, and years. It can take months or years to recover. Some years many active funds beat it, some years bond indexes beat it, some years other indexes beat it.

  • This doesn't seem to address the question - which is whether or not bankrupt companies are reflected in the index and if an individual investor would get a different return than expected. doesn't straightforwardly mean that investing in a fund that follows the Dow Jones is always good, since the risk of failure isn't reflected in the value of the Dow Jones – Chris Sep 6 at 19:56
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The Dow (Dow Jones Industrial Average) is composed of 30 large, publicly owned companies based in the United States. As you said, the value of the Dow is not market capitalization-weighted, but rather the sum of the price of one share of stock for each component company, adjusted for dividends.

The components of the Dow have only changed 52 times since its beginning in 1896. The Dow stocks are the best blue-chip stocks listed on the NYSE and NASDAQ exchanges. They are switched out of the index long before they go bankrupt. No DJIA company has ever gone bankrupt while it was still part of the DJIA. That is why the performance of the Dow does not have the sort of survivor bias that you asked about.

  • This does not really answer the question, only gives information about the DJIA. – Pete B. Sep 4 at 19:52
  • But doesn't that mean that the survivor bias comes right back in by switching out underperforming companies in the index for overperforming companies not yet in the index? – sgf Sep 5 at 6:39
  • @PeteB. It answers the question in so far as it states that Dow components don't really change that much. On the other hand, it has changed about 170% of its components since 1896, so that's not nothing either. – sgf Sep 5 at 6:47
  • @PeteB. The question explicitly asks about the DJIA. That is what I answered. The same answer applies to the S&P 500. I worked as a ratings analyst for Standard & Poors. – Ellie Kesselman Sep 5 at 12:20
  • @sgr The composition of the index is very stable over decades. – Ellie Kesselman Sep 5 at 12:22
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Why would there be a problem? A bankrupt company would be removed from the index at a price of zero, or close to it. They don't retroactively remove the company back when it was at its peak.

  • Consider the following scenario: There's an index with two companies: One at a value of a 100, one at a value of 50. The index average is 75. Next year, the weaker company goes bankrupt, while the other's value increases to 120. Now the index average is 150. If the index were still counting the bankrupt company, its index average would be 60. The index average has risen, but an investor that invests $100 in both indexes at year 0, $200 in total, finds himself with stock worth $120. If he sells now he has lost 40% by investing in an index fund of a index that has gained 100% in value. – sgf Sep 5 at 18:17
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    I am not going to consider that scenario, because that is not how indexes work. – jjanes Sep 5 at 19:34
  • @sgf To try to identify and help with your issue: Why do you say the new index average is 150? How do you get that number when the surviving company is at 120? – nanoman Sep 6 at 2:09
  • @nanoman My bad, it's now 120 of course. – sgf Sep 6 at 6:57
  • @jjanes To reach that conclusion, you have to have considered it already :) But please enlighten me: If this isn't how indexes work, how do they work? Is the value of the Average not the average of the values of the components? – sgf Sep 6 at 6:58

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