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.
