The great stock myth

I was doing some research the other day and I found out something really interesting. All these years I've been hearing that stocks provide a great rate of return, with the Dow Jones averagine something like a 7% rate of return since its inception. While this isn't the astronomical level that we'd all like, I've found out that it's actually an "inflated" number.


By inflated, I mean that the Dow Jones has been growing at an anualized rate less than 7% over its history. By my calculations the Dow Jones grew at a rate of 5.457% over the first 105 years of its existence.


To understand the discrepency all you have to do is think about how average affects the rate of return. Consider an investment over ten years. For simplicity we'll assume that your investment never depreciates on an anual basis, i.e. growth will be non-negative. If you average a rate of return of 5%, you will have at a minimum of of 150% of your initial investment (50% one year, 0% the rest). On the other hand if you earn 5% every year you'll have 163% of your initial investment.


Given that the "classic" index only yeilds about 5.5% over the long haul, wouldn't it be more prudent (for the naive long term investor) to put your money 30 year T-Bonds where you can -- even today -- get a yeild in excess of 5%?


- Andrew

Andrew: Did your data source include dividends? Dividends are at a low point for the Dow but yielded more than bonds until the 1950's. A 2.5-4.0% boost from dividend yield for the first fifty years would probably put the Dow over 7% annualized. Russ.

I don't really study nor care about the Dow as it is a terrible index but the SP500 averages about 12% a year. As do all major, broad and properly constructed indexes.

I have to admit that russ brings up a good criticism when he mentions dividends. I did not take those into acount when I calculated the anualized return.


But your criticism really is "head in the clouds" delusional. I don't think you'll find any credible research which indicates that 12% anual growth over the broad market is a legitimate expectation.


I've done some more web research, and it seems that somewhere around 7% is what you can expect across a diversified portfolio over the long haul.


- Andrew

The Dow is a poor average for doing this kind of analysis since it is a price weighted average as opposed to a market cap weighted average. For argument's sake let's say that some other appropriate index does yield similar results. As Russ pointed out dividends come into play it depends on what you do with dividends. If you reinvest them then given todays tax structure they should be reinvested after taxes are paid on them. I don't know how dividends have been treated tax wise throughout the period you mention. If you don't reinvest dividends then I think that they are far less significant. Another point would be how practical is it to reinvest dividends given transaction costs? Today transaction costs are not nearly as high as they were 15 years ago. I'll admit I really don't know the effect of this. The other thing I would think becomes very relevant is the tax treatment of stocks vs. bonds since stock price appreciation is treated differently tax wise than bond coupon payments.

Unfortunately your "research" doesn't cite sources. But www.ibbotson.com (http://www.ibbotson.com) has shown U.S. common stocks have earned an average rate of return of around 16% since 1926, or a compound rate of return of around 12%.


Put it this way: $1 invested at the beginning of 1926 in a broad portfolio of U.S. stocks would have been worth over $500 at the end of 1990. And the 1990's had a great bull market.

Sources?


What kind of sources do you need? The dow opened at 40.94 on May 26, 1896. The dow closed at 10990 on May 28, 2001. This gives an anualized rate of return of 5.47%


I grant that this doesn't include dividends, and that the Dow mightnot be the best measure of universal stock growth, but the numbers are solid.


- Andrew

I figure your all close to being right. But I'm a very conservative player and investor. So, I'm just going to hold my investments for the next hundred years to see what the actual return really is.

I thought i might try and help settle your dispute. Copy and paste the link in this post into your address window. Then click on the chapter one (you need powerpoint to view this) Look at slide 14. Large cap stocks have actually returned about 12% annually since 1929.

http://www.uky.edu/~bjordan/BDJWeb/Fin450/invest.html

7% is a bond like return. Not only are the actual numbers against you but the market wouldn't invest in stocks if broad diversity on gives you 7% with all the risk when you could get almost the same in municipal bonds(with no taxes).


As for credible research...stop doing the math yourself. Ignoring dividends in DOW component stocks(or any stocks) is ludicrous. If you haven't figured that out I don't know what to tell you.

As an aside, it is interesting to think that if every baby-boomer had begun investing the money he has today at the bottom of the 1930 Bear Market, he would have X zillion dollars today.


It is interesting to think that, what, 500 billion dollars would have to be invested in a collection of companies with probably under 100 million in revenues. Talk about P/E multiples!


To respond to their demand for 1930's-priced investments, venture capitalists would have had to respond by building a thousand new businesess, and inventing a thousand new products. It would have taken 70 years!


But that is the whole point, that neither their money nor the investments were available in 1932. To assume your stock price will rise from here to the future, is to assume that the demand for investments will continue to rise faster than supply, as people get more productive (have more to set aside for a rainy day) and live longer.


El-Roi