The Dow Jones Industrial Average represents the best of the best, right? The best companies. The best stocks. The best cross-section of the best companies and stocks and industries in the best economy in the world.
That’s why the DOW includes General Motors, of course. And Shitigroup.
Those Dow people can’t stand having crappy stocks mucking up their index, by the way. That’s why they added Microsoft and Intel to the DOW at the peak of the tech bubble and booted Chevron and Goodyear to make room (and then added Chevron back eight years later, when it was up 60%). And that’s why they will soon be punting GM and Shiti to the moon.
But does all this monkeying around with the index really help? Actually, no. It hurts. Investors would have been far better off if the folks who created the first Dow 30 back in September 1928 had left strict instructions never to mess with it.
[I]n November of 1999, Goodyear and Chevron were removed in order to allow Microsoft and Intel to join the Dow 30, where the two tech giants proceeded to rise handily the next few quarters. However, it has not been that pretty since the end of 2000, with both stocks down approximately 60% from their entry price, and much further from their peak price. Chevron proceeded to move up some 60% in price after it was removed, at which point Chevron was inserted back into the Dow 30 on February 19, 2008, where it is now down about 15%. Not a good run for the selection committee.
But it is not all bad. If you look at the deletions and additions, you find some interesting timing issues. Some additions were excellent in terms of performance. Some avoided later bankruptcies.
How much has all the tweaking hurt returns? John continues, citing a note sent to him by Rob Arnott:
As Rob noted to me in the email he sent with the data, “If Dow Jones hadn’t tinkered with the index, the 30 companies would have merged or failed their way down to just 9 survivors. Of the 21 companies in the original 30 that are now gone, 20 disappeared through M&A, some were replaced by successor firms and others not, and only one (Bethlehem Steel) failed outright.
But this no-fiddling index would have topped out at just over 30,000 in October 2007 and would have finished 2008 at 14,600. Ugly decline, but not as ugly as a level of 8776 [now down to 7300 as I type this]. This compounds out to a 0.7% per year greater return than the actual Dow 30 results. The difference comes from dropping companies when they’re out of favour, and trading at deep discounts, only to replace them with popular large-cap, high-multiple newcomers.”
That 0.7% advantage may not sound like much, but over 80 years, it adds up:
That “Original 30” gives us an annual return of 9.6%. Just 0.7% a year, so you might think, not much difference. But if you start with $100 and compound it for 80 years, that 0.7% becomes a quite large differential. With the Dow 30, your $100 would have grown to $96,993 as of December 2008, but the Original 30 would have grown to $161,603.
Then there’s that weird “price-weighting” methodology that the DOW people use. That screws you over, too.
[T]here is an even bigger differential if you simply equal-weight the components rather than use a price-weighting methodology. Your $100 grows at a 10.4% clip and becomes $272,554, or almost three times the actual Dow 30. This is probably due to the fact that, whenever a change was necessary, it would be natural to add one of the more popular and respected large-cap growth stocks that wasn’t already on the list. It’s hard to earn a “risk premium” on assets that are not seen as having much risk!
See Also: Stocks For The Long Run, 7