Dow 1,000,000?

While the Dow Jones Industrial Average is one of the most widely quoted stock market indexes, it is well known to have many shortcomings. Specifically, it is price weighted (most indexes are value weighted), and that the 30 companies included are arbitrarily chosen.

But there’s an even bigger problem: it excludes dividends. This doesn’t matter much day-to-day, but it does matter a lot in the long run.

A new working paper, “Replicating the Dow Jones Industrial Average,” looks at both of these problems. First, they find that while price-weighting is weird, it doesn’t matter much. Also, if you just used the 30 largest companies in the US, rather than the 30 that are somewhat arbitrarily included, the return doesn’t change much. Either way, you get an average annual return of between 6.5% and 7.0% over the period 1929-2019. The DJIA is indeed a weird index, but that doesn’t seem to matter.

But the exclusion of dividends (and their reinvestment) is a massive problem over the long run. The authors find that the DJIA would have finished 2019 at a value over 1 million (specifically: 1,113,047) if dividend reinvestments were included (referred to as the “total return” index) rather than the 28,538 that it actually closed at. In other words, the average annual return of the DJIA from 1929-2019 was 11% rather than 7% (these are nominal returns, not inflation-adjusted).

If you know anything about compound growth, this is huge! At 11%, an investment will double roughly every 6 years rather than roughly every 10 years at 7% (using the rule of 70, or more precisely the rule of the natural log of 2). Over a 90 year period, that means the investment will be worth 40 times as much. Even using a log scale, as the chart here does, the dramatic difference is clear when you include dividends.

Economists can’t offer too much in the way of investment advice, other than: get your money into an index fund! Now!

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