$1 invested in stocks in 1802 was worth $755,000 in 2006″

Today, I read an article by Ms. Morgan Housel, who was writing for the Motley Fool, in which she claimed that the stock market is a good place to invest because: “$1 invested in stocks in 1802 was worth $755,000 in 2006”.

One should pay no attention to any commentator that uses statements like “$1 invested in stocks in 1802 was worth $755,000 in 2006” as Ms. Housel did here. First, it is not possible for any investor to wait 210 years to realise such a result. Second, some simple arithmetic with a pencil and paper will indicate that it is impossible to actually obtain any appreciation nearing that measured by any index that you chose over the very long term.

As to the second point, companies come and go. Bankruptcies occur and companies simply close their doors and go out of business. The indicies select only the companies then remaining in the market and adjust the value of the index to account for both the removal of the company that went out of business and the inclusion of the next company in line to join the index. As an individual investor, we must live with the loss accompanying the loss of a company. We do not have the privilege of living in the fantasy world that is populated by those computing the value of the various indicies.

The above quoted concept, which I have seen used repeatedly by commentators parading their wares, is misleading at best and a downright lie at worst. Each index, whether it be weighted by market capitalization, equally weighted, or value weighted, is adjusted daily based upon the criteria used to compute the value of the index. Even if one attempted to match the index of choice, it would not be possible to match the long-term performance of the index. This is one reason that Exchange Traded Funds tend to fail miserably at what these are claimed to do. This is because in computing the value of the index, no consideration is given to the transaction costs associated with buying or selling a certain number of shares according to the formula used to compute the value of the index. Further, computation of the value of the index at any point in time fails to include the spread between the bid price and the sale price of the share. It is not difficult to see that even the two costs associated with real engagement in the market will cause a strong downward pressure on the computed value of the index over a long period of time.

Before Ms. Housel starts spouting further statistics about a dollar growing to fantastic amounts of money over more than two centuries, I suggest that she does the following: (1) set a more reasonable starting time, say 12th April 1995; (2) select an index as it stood on that date, say the ^DJIA; (3) account for the losses associated with every company that was dropped from the ^DJIA between 12th April 1995 and the current date; (4) account for the cost of purchasing sufficient shares in the company that replaced the company identified in enumerated item (3); (5) account for the transaction cost of sale and purchase of sufficient shares in each company to match the adjustment required by the formula used to compute the ^DJIA; (6) account for the spread between the bid price and the sale price for each sale and purchase identified in item (5); and, (7) account for the taxes, including income and capital gains, associated with the aforementioned sale and purchase and any dividends that might have been distributed during the holding time. Finally, I challenge Ms. Housel to rationally compare the result obtained according to the real world implementation of the ^DJIA as described above with results obtained by buying 10-year treasuries, or municipal bonds, over that same period of time.

I am willing to wager the following: (1) that Ms. Housel will find that using the real world steps identified above will give a result on 3rd March 2012 of either a 0% increase over 12th April 1995, at best, or will be in the negative territory; (2) that the performance of 10-year treasuries or municipal bonds over that same period of time will beat the pants off of any real world strategy that includes the steps identified above.

By the way, the Gardner brothers parade the increase in their selected portfolio month after month. Has any one ever bothered to work out the average compound annual growth rate of their portfolio? I checked a couple of months ago and it was no better than 7.2%. Long term, the market exceeds 10%. My point is made.

Nathan A. Busch

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