Interviews with Digital Media Thought Leaders

Question Stock Investment Returns

Podcast Audio | Posted by Phil Leigh on November 27, 2012

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As noted in my last post, I originally read “Adam Smith’s” The Money Game at the peak of a speculative market in 1968. Since then there have been a least three additional frightening collapses: (1) Junk-Bond Takeover Bust of the late 1980s, (2) Dot-Com Bubble at the turn of the century, and (3) Great 2008 Recession. Investors who experienced those events no doubt remember the losses as massive. Yet despite three debacles, the Dow Jones Industrial Average increased nearly 1,400 percent since 1968 providing a compound annual rate of return of almost 6%. Moreover, academic research normally uses the Dow -or similar – index as a proxy for overall stock market performance.

I question whether the six percent figure is valid.

The reason I doubt it is because the Dow Jones appears to be a “rigged” Index. Furthermore, all indexes seem to be similarly “rigged” for two reasons.

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Frist, many of the most popular stocks during a speculative boom that later go bust, never get into the applicable index. Two examples are National Student Marketing and MP3.Com each of which once traded at over $100 per share. Both were popular with “performance” mutual funds, which means a great many investors were indirect shareholders. The endowment funds of the University of Chicago, Harvard and Cornell held stock in National Student Marketing as did Morgan Guaranty, Bankers Trust, Northern Trust, and General Electric Pension.

The situation would not be so discouraging if it were only speculators who failed to match the presumed 6% compound annual return rate. But upon comparative inspection I learned that only 8 of the 30 Dow Jones stocks in 1968 remain in the index today. Thus, the second reason to doubt the 6% statistic is that the Dow Jones Industrial Average fails to be an internally consistent Index. Moreover, the same inconsistency applies to every index, although the flaw is more easily demonstrated with the Dow.

To be specific, formerly mighty companies presently in decline tend to be replaced by stronger ones. For example, if XYZ Corporation has been declining for ten years it can be replaced by ABC Corporation that has been growing over that same period. Thus, the ten-year downtrend of XYZ is taken out of the index and replaced by the ten-year uptrend accumulated by ABC. Unfortunately, investors who owned XYZ over that period cannot pretend they did not actually own them. If they sell the stock in their portfolio and replace it with ABC, they must take a loss in the XYZ. Furthermore, unlike the index, their portfolio does not get the benefit of the rising ABC trend for the previous ten years simply because they didn’t own any share of the company. In contrast, the index essentially gets to pretend that it did.

Unfortunately, substitution into the Dow Averages happens more often that the might be supposed. For example, in 2004 Kodak was replaced by AIG Insurance, but AIG was replaced by Kraft in 2008, and earlier this year Kraft was replaced by United Healthcare. As the graph below illustrates, the removal of AIG probably had material, favorable, and artificial impact on the Dow Averages. As may be seen, AIG lost about 97% of its value over 2007 – 2009.

As a qualification, my analysis assumes that the Dow’s historical performance is recalculated to reflect the removal of AIG and its replacement by Kraft. If the historical performance is not changed when Kraft is “substituted in” then the subsequent index performance is more valid. However, I have been unable to clarify the point and presume the historical index values are recalculated when a new stock enters the Dow.

In conclusion, there appear to be at least two objective reasons to question whether the Dow Jones Averages – or any index – are a legitimate proxy for average historical returns in the stock market.