Security Market Index

A security market index represents a given security market, market segment, or asset class, usually constructed as portfolios of marketable securities, known as constituent securities.  Indexes help investors track performance and risk, benchmark active managers, and invest in broad markets at low costs. An index may have two versions: a price return index, which tracks only the price of constituent securities, and a total return index, which accounts for reinvestment of interest, dividends, and other distributions.

Question

Assuming an index is made up of dividend-paying stocks, what type of index would likely post higher long-term returns?

A. Price return index

B. Total return index

C. Neither, price and total returns should be exactly equal

Solution

The correct answer is B.

Since dividends are assumed to be reinvested back into the total return index and not the price return index, the total return index will outperform as dividends are added in and compounded over time.

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