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A security market index serves as a representation of a specific security market, market segment, or asset class. It’s typically built using portfolios of marketable securities called constituent securities. These indexes play a significant role for investors by allowing them to monitor the performance and risk within a particular market, compare the performance of active managers, and make low-cost investments in broad markets. There are typically two versions of an index: a price return index that tracks only the price changes of constituent securities and a total return index that factors in reinvested 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?
- Price return index.
- Total return index.
- Neither; price and total returns should be exactly equal.
Solution
The correct answer is B.
The total return index is calculated with reinvested dividends, which makes it outperform the price return index. This happens because dividends are reinvested, leading to compounding over time.