By Gary Brooks, CFP®
When Apple replaces AT&T in the Dow Jones Industrial Average on March 18, all previous performance for this commonly cited investment index will become even less relevant.
The Dow is meant to be a barometer for the broad market even though it includes just 30 stocks of giant U.S. companies considered to be industry leaders.
Every time the constituents of the index change, the past returns become less meaningful. Many people look to past returns and extrapolate an estimate of future returns. For example, the Dow Jones Industrial Average has produced 8.9% average annual price appreciation over the past 25 years, therefore that is what we expect it to produce for the next 25 years.
But past performance is not indicative of future results and it can be dangerous to count on in any way.
“For past averages to be meaningful, the data being averaged must be drawn from the same population,” writes Bradford Cornell in The Equity Risk Premium. “If this is not the case — if the data comes from populations that are different — the data are said to be non-stationary. When data are non-stationary, projecting past averages typically produces non-sensical results.”
The exactness of past performance, documented in many forms – annual returns, average returns, standard deviation of returns, rolling returns, risk-adjusted returns – is misleading when it is derived from any investment or benchmark that no longer exists in the same form.
Consider what the Dow return would have looked like if Apple had been added to the index in 2008 instead of Bank of America (which was then removed from the index in 2013).
Source: Bloomberg (http://www.bloomberg.com/news/articles/2015-03-11/what-if-apple-had-been-chosen-for-dow-in-2008-chart-of-the-day)
The Dow adds and subtracts irregularly.
In and Out of the Dow (the past 10 changes)
|Date of change||Stocks removed||Stocks added|
|March 19, 2015||AT&T||Apple|
|September 23, 2013||Alcoa, Bank of America, Hewlett-Packard||Visa, Nike, Goldman Sachs|
|September 24, 2012||Kraft Foods||UnitedHealth|
|June 8, 2009||Citigroup, General Motors||Cisco Systems, The Travelers|
|September 22, 2008||American Intl Group (AIG)||Kraft Foods|
|February 19, 2008||Altria, Honeywell||Bank of America, Chevron|
Each change in its population makes previous returns less useful for future comparison. And selection of which companies are in the index makes a tremendous difference.
Consider IBM. It has been in the Dow, out and back in. IBM was taken out of the Dow in 1939 and added back in 1979. According to Eddy Elfenbein, over that time, IBM gained 22,000%. “If IBM had remained in the Dow, the index would have had nearly twice the value.”
This isn’t a phenomenon of the Dow. Morgan Housel recently wrote an article looking at the S&P 500 and how it has seen over 1,000 companies enter and exit the index over the years.
Companies die. Companies shrink in relation to the size of the market, their industry or the overall economy. Industry leadership rotates during different environments. Global factors, consumer demographics, shifts from manufacturing to service economy, technology advancement, corporate taxation, currency values … all of these variables, and others, change the characteristics of the population being measured by any benchmark over time.
What the S&P 500 returned in 2014, since 2000, or any other time frame provides a point of reference but it doesn’t tell us anything really of what the next year or decade’s returns will be. Rather than focusing on whether or not your investments kept up with an appropriate benchmark, it’s more important to first trust that you are implementing a quality investment process and that your future savings is commensurate with the size of your future goals (obligations). While everything else around you is changing, these are two things that you can control.