The selection of index constituents creates a bias in our understanding of the market. This bias is tilted even further when we consider that underperforming stocks are dropped from the index every few months and outperforming stocks are added. It is called survivor bias because only “winners” are included, so the index always appears to increase over time.
Market indexes hide a multitude of errors and opportunities because they average the performance of stocks in one way or another. The fabled Dow tracks just 30 stocks. The S&P 500 is more representative, tracking 500 stocks selected based on market capitalisation, liquidity, profitability and the public float available for trading.
This index construction means that the so-called Magnificent Seven stocks exert undue influence on the behaviour of the index, making up most of the momentum for the upward rise.
