Tuesday, September 25, 2012

total return index

For most investors, the stock market, as they know it, is  the Dow Jones (INDEX: ^DJI) and the S&P 500 (INDEX: ^GSPC) . For the media, the two represent everything. How's the market doing? Better cite the Dow or the S&P.

It's unfortunate, really. Both indexes that we've come to obsess over have flaws. The Dow weights its components by share price, giving IBM (NYSE: IBM) 22 times the weight of Bank of America (NYSE: BAC) . No one I know has ever rationalized this practice. The S&P is weighted by market cap, which makes more sense, but often skews it toward the market's most overvalued companies.

Yet, both share a more glaring defect: They don't include dividends.

We fixate over how much the market indexes have gone up or down in the last month, year, or decade. But since the S&P 500 was created in 1957, one-third of average annual returns have come from dividends. Assuming dividends are reinvested, rising market prices on shares purchased with dividend proceeds means 82% of the market's cumulative return is the result of reinvested dividends. Why would we ignore that? It's the equivalent of measuring how much your child has grown while ignoring everything from the neck down.

Ironically, Standard & Poor's calculates a "total return" index that adjusts for dividend payments. But few pay attention to it, particularly in the media. In the last decade, the S&P 500 Total Return Index has been mentioned in news articles fewer than 100 times, according to Google.

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