Why do stock indices matter?
Temple of Theseus, Athens. Source: Trustees of the British Museum
Theseus, the founder-hero of Athens, lived around 1200 BC. In order to keep his memory alive, Athenians are supposed to have preserved his ship, taking out planks and timbers as they rotted, installing new materials in their place. Over time, all of the original wood was replaced. After some centuries, philosophers asked, was Theseus’ ship in any sense the “same” ship?
This question is known as “Theseus’ Paradox” and has several resolutions. I thought about it recently when Apple was added to the Dow Jones index, replacing AT&T. The Dow has been with us for over a hundred years, using about 30 stocks to represent the market. But over time, all the components have been replaced. In what sense is it the same index?
The answer lies in what it is used for. The Dow, like Theseus’ ship, represents something larger. With Theseus’ ship, it’s the heroic Athenian ideal, with his triumphs and tragedies. In the case of the index, it’s a proxy for the market. When we say that the market is expensive or cheap, we’re saying that the average component is pricey or a bargain. And the index also maintains its identity because of its history—just as an individual person is the same person, even though each part of us may change over time.
This is relevant to investors today. The growth of Exchange Traded Funds has created a boomlet in the creation of new indices. Today you can get an index comprised of just about anything—value stocks, growth stocks, stocks that start with the letter “C.” And they all claim to beat “the market,” as defined by some other index. But be careful! Most of these indices have no real history. They’ve been constructed using new criteria and back-fitted. The hypothetical returns they claim weren’t ever available to investors.
And like Theseus’ ship, consider their purpose. They aren’t built to track the market, or even a portion of the market. Their real objective is to support a new financial product—one that will appeal to current fads and fashions. When tastes change, these new indices will, too—or else be left as financial orphans. And no one knows what will happen to their shareholders.
Theseus’ original ship was real—it carried him on his voyage home. Investors should make sure that what they use to carry their savings will stick around, and not end up in a financial museum.
Douglas R. Tengdin, CFA
Chief Investment Officer
Leave a comment if you have any questions—I read them all!