Tuesday, September 11, 2007

Here's Why You Don't Pick Stocks

According to Wikipedia, the Dow Jones Industrial Average was first introduced to the world on May 26, 1896, just over 111 years ago. The original Dow components were:

American Cotton Oil Company
American Sugar Company
American Tobacco Company
Chicago Gas Company
Distilling & Cattle Feeding Company
Laclede Gas Light Company
National Lead Company
North American Company
Tennessee Coal, Iron and Railroad Company
U.S. Leather Company
United States Rubber Company; and
General Electric

I don't know about you, but the only name that rings a bell in that entire list, and the only one of the original list that is still on the Dow to this day, is General Electric.

Here is the lesson that I am taking away from this change in the Dow: given enough time, even the bluest of blue chips fail and disappear. I have to ask myself whether investors in the stocks that faded into obscurity saw the change coming and bailed out and how many of them lost a bundle by betting on these stocks.

When the Dow was first introduced it stood at 40.94. When the market closed yesterday the Dow ended at 13127. So while the index itself soared over 32,000% over its existence, many of the underlying stocks disappeared. This is not exactly a scientific case for index investing, but if you are into stock picking this should make you pause and ponder for a while.

Incidentally, in writing this post I ran a quick calculation based on the numbers I quote above, and it appears that over its entire existence the Dow averaged a return of about 5.4% per year. Does that not strike you as unnervingly low? I think I will dig into that a little bit more. I'll let you know what I come up with.

5 comments:

Anonymous said...

Hi Shadox

My quick investigation showed that while few of the companies remained under the same name (GE, Laclede) none of the companies went under and many rolled into other companies, or split into sub companies. For example american tobacco split into:

* American Tobacco Company
* R. J. Reynolds
* Liggett & Myers Tobacco company
* Lorillard

It is a little difficult comparing stock prices because of the changes and many splits, but I am not sure buying say, only GE stock for the last 100 years would be worse than the DOW....

Kevin said...

I get 5.335% accounting for compounding.

That sure is a lot less than the 8% historical market return that you usually hear quoted.

Of course, the DJIA is NOT the same as the market and not that good a proxy for the market. The S&P is probably a better measure of market performance.

Interesting none-the-less!

Shadox said...

Anonymous,

You make an excellent point. My article does not account for mergers, acquisitions, splits and name changes and that is a big hole in my analysis. Neverthelesss, my point is not that you would not have made money by investing in GE, but rather that you have far better chances of picking the long run losers than you do the long run winners - simply because there seem to be more of the former.

Kevin,

I completely agree that the Dow is too narrow a meaure. Take a look at the post I will publish tomorrow. I take a more comprehensive look at several other indexes.

Anonymous said...

What about dividends? They could significantly alter that 5% average.

Shadox said...

You are correct. Dividends are not taken into account and they could significantly increase the return.