Yields of Dreams: An Informed Look at Dividends

Many Investors in recent years have developed a preference for stock dividends to generate income needs. In today’s historically low interest rate environment, such stocks are more attractive than the familiar bonds or bank CDs they used to buy and hold.

But dividend strategies with stocks are not the only way to produce income. Moreover, investors should be aware of the potential tradeoffs and unfamiliar investing risks that accompany a portfolio managed to provide income primarily in the form of dividends. While dividend-paying shares appear to have a reliable schedule (quarterly, in many cases), much like the bonds conservative investors favored for so many years, the cash to fund a dividend must come from somewhere, and it does so very differently than a bond.

We know the price of a stock is influenced by all expected future cash flows to the firm, and thence to shareholders. If cash is paid today in the form of a dividend (rather than be retained for future growth), the stock price — and total market capitalization — of the issuing company should be expected to fall by a corresponding amount, such as in hypothetical Portfolio A in Exhibit 1, below. That means, all else being equal, shareholders who receives a dividend are left with a equity holding made less valuable by that dividend.

Chart comparing methods of income generation Chart showing income via stock sale - Portfolio B

CASH CONSIDERATIONS

A simple alternative method of raising cash for income when needed is to simply sell shares. Firms like Charles Schwab have $0 commissions with on-line trades. Exhibit 1 compares these two methods of generating income by contrasting hypothetical Portfolio A with the similarly valued Portfolio B. While Portfolio A receives income through a periodic dividend payout, Portfolio B generates it through a stock sale.

The investor in Portfolio A, in which a dividend is issued, ends up holding the same number of shares as were held prior to the dividend payout — but we assume that those shares have declined in value. The investor in Portfolio B holds a reduced number of shares with no value decrease because of no dividend payout. The two approaches arrive at the same place—both investors end up with $100 in cash and $1,900 in stock, notwithstanding potential trading costs or tax implications, if any. But the dividend approach has potentially greater downsides in contrast to the stock-sale approach.

First, the average proportion of U.S. firms paying dividends was about 52% from 1963 through 2019,1 meaning an investor focusing only on high dividend stocks excludes nearly half of all investible U.S. companies. A second consideration is that a dividend’s value, while not subject to stock price fluctuations, isn’t guaranteed. Just 10 years ago following the financial crisis, more than half of dividend-paying firms cut or eliminated those payouts.2 More recently, a venerable company that had consistently paid dividends for more than a century, General Electric, slashed its payout to just one cent a share.3 The UK’s Vodafone Group cut its full year dividend for the first time in two decades.4

Thirdly, investors lose flexibility with the timing and the size of payouts when they rely on company-issued dividends. With stock sales, an investor determines both the amount and the best income schedule for them. And lastly, dividend-focused investors tend to substantially under-diversify, typically owning only a limited number of stocks, thereby incurring unnecessary risk—the fewer the stocks, the greater the uncompensated risk.

Graph showing income facts - Exhibit 2

Source: Dimensional calculations using Bloomberg data. For constituents with reported returns of less than one year, returns shown since earliest date available. S&P data© 2020 S&P Dow Jones Indices LLC, a division of S&P Global. Dividend yield is calculated as the sum of dividends paid in calendar year t divided by end of year t-1 price.

TOTAL RETURN

When considering an investment strategy, it is equally important to assess the potential total return, which accounts for capital appreciation (or loss) alongside dividend income. High dividend yields does not mean high total returns. Exhibit 2 plots the trailing 12-month returns of S&P 500 Index constituents as of December 31, 2019 (each dot representing a company). Those companies with greater dividend yields—the dots located higher up the vertical axis—weren’t consistently those with a higher total return.

The need to prioritize income generation may be important for many investors, but that objective should not preclude other important investment considerations, such as diversification and flexibility. While the use of stock sales instead of dividends to create cash flow may involve trading costs and tax considerations, there are growth benefits for investing in companies that don’t currently pay dividends. An informed investment planning strategy focused on income should balance broader concerns such as longevity that do not exclude safer allocations into fixed income and annuity income approaches.

NOTES

1Source: Dimensional, using data from CRSP. Stocks are sorted at the end of each June based on whether a dividend was issued in the preceding 12 months.

2Stanley Black, “Global Dividend-Paying Stocks: A Recent History” (white paper, Dimensional Fund Advisors, March 2013).

3Janet Babin, “GE cuts dividend to a penny per share. Why bother keeping it at all?M” arketplace, American Public Media, October 30, 2018.

4Adrià Calatayud, “Vodafone cuts dividend after swinging to 2019 loss.”M arketWatch, May 14, 2019.

Tuning Out The Noise

When faced with short-term noise, it is easy to lose sight of the potential long-term benefits of simply staying invested.

For investors planning their goals, it can be easy to feel overwhelmed by the relentless stream of news about markets. Being bombarded with data and headlines presented as impactful to your financial well-being can evoke strong emotional responses from even the most experienced investors. Headlines from the “lost decade”1 can help illustrate several periods that may have led market participants to question their approach.

  • May 1999: Dow Jones Industrial Average Closes Above 11,000 for the First Time
  • March 2000: Nasdaq Stock Exchange Index Reaches an All‑Time High of 5,048
  • April 2000: In Less Than a Month, Nearly a Trillion Dollars of Stock Value Evaporates
  • October 2002: Nasdaq Hits a Bear-Market Low of 1,114
  • September 2005: Home Prices Post Record Gains
  • September 2008: Lehman Files for Bankruptcy, Merrill Is Sold

While these events are now more than a decade behind us, they can still serve as an important reminder for investors today. For many, feelings of elation or despair can accompany headlines like these. We should remember that markets can become very volatile and recognize that, in the moment, doing nothing may seem paralyzing. Throughout these ups and downs, however, if one had hypothetically invested $10,000 in US stocks at the end of 1999 and simply stayed invested and done nothing, that investment would be worth approximately $33,500 today.2

When faced with an ongoing barrage of short-term noise from the media, it is easy to lose sight of the potential long-term benefits of simply staying invested. While no one has a crystal ball, adopting a long-term perspective can change how you can view market volatility and help you look beyond the headlines.

THE VALUE OF A TRUSTED PROFESSIONAL

Part of being able to avoid giving in to emotion during unexpected periods of uncertainty is having an appropriate asset allocation that is aligned with your personal willingness and ability to bear risk. You must realize that if investment returns were guaranteed, you should not expect earning an equity premium greater than a risk-free rate of return.

Fundamentally, risk and expected return are inextricably related. Constructing a portfolio that you can tolerate, understanding that all uncertainty is at the core of investing, and sticking with an informed planning is much more likely to lead to a better investment outcome for planning goals like retirement.

However, as with many aspects of life, most of us can benefit from some help in reaching our goals. Just as athletes work closely with a coach to increase their odds of winning a medal, many successful professionals rely on the assistance of a mentor or career coach to help them manage the obstacles that arise during a career. Why? They understand that the wisdom of an experienced professional, combined with the discipline to forge ahead during challenging times, can keep them on the right track.

A qualified and experienced financial professional can play this vital role for an investor. A true financial professional, such as a Certified Financial Planner® or a Wealth Management Certified Professional® can provide the expertise, perspective, and encouragement to keep you focused on where you want to go and help you stay in your seat when it matters most.

A recent survey conducted by Dimensional Fund Advisors (see Exhibit 1) found that, along with progress towards their goals, investors place a high value on the sense of security they receive from their relationship with their trusted financial professional.

Having a strong relationship with a trusted financial professional can help you be better prepared to live your life through the ups and downs of the market. That’s the value of discipline, perspective, and peace of mind. That’s the difference a true financial professional can make.

Successful retirement and wealth planning is more than investment management. A competent CFP® wealth management professional can help you plan your future with confidence.

Exhibit 1:

Value Received from your Advisor graphic

1For the US stock market, this is generally understood as the period inclusive of 1999–2009.

2In USD. As measured by the S&P 500 Index. A hypothetical portfolio of $10,000 invested on January 1, 2000, and tracking the S&P 500 Index, would have grown to $33,500 on December 31, 2019. However, performance of a hypothetical investment does not reflect transaction costs, taxes, or returns that any investor actually attained and may not reflect the true costs, including management fees, of an actual portfolio. Changes in any assumption may have a material impact on the hypothetical returns presented. It is not possible to invest directly in an index.

Source: Dimensional Fund Advisors LP.

Hindsight Is 20/20. Foresight Isn’t.

The year 2019 provided many examples of unpredictable markets.

Interest rates that U.S. policy makers expected to rise, instead fell. American consumers’ confidence weakened as the year began,1 and news headlines broadcast fears of a pending economic slowdown. Market returns of the month of December 2018 were the worst for any December since 1931.

Many fearful investors who temporarily chose to move from stocks into cash and intended to stay there “until things looked better” missed some of the biggest U.S. stock market gains of the year. As of the end of November, the S&P 500 was about 25% for the year on a total-return basis. That puts this year on course for the best showing since 2013.

Outside the U.S., Greece—the site of a recent economic crisis so dire some expected the country to abandon the euro, and whose equity market lost more than a third of its value last year—has had one of the most robust stock market performances among emerging economies in 2019. On top of that, Greece issued bonds at a negative nominal yield, meaning investors actually paid for the privilege of lending to its government.

These events remind us that the game of making predictions can be costly for players.

UP OR DOWN?

A closer look at interest rates and bond markets shows just how unpredictable normally staid fixed income asset performance can be. Going into 2019, Federal Reserve officials expected economic conditions to support raising a key interest rate benchmark twice. Instead, over the course of the year, those policy makers lowered rates three times.

In the global capital market for U.S. Treasuries — where participants competitively set interest rates — the yield curve that tracks Treasuries inverted for the first time in more than 10 years. See Exhibit 1, below. Some long-term yields fell below short-term yields over last summer. What’s more, while yields on medium- and long-term bonds were at historically low levels early in the year, yet they fell lower. Investors who made moves into cash or short-term bonds betting on rising yields were severely disappointed as events transpired. Bond returns in 2019 turned out to be the best in years. But those who stuck with a sound planning strategy were able to profit.

Graph: Shifting Curves Yields on US Treasuries of various maturities since the end of 2018

TRADING PLACES

In equity markets outside the U.S., anticipating events wasn’t any easier. Exhibit 2 shows no evidence that links good performing markets in 2018 and those that excelled in 2019.

Among the 23 developed market countries,2 only one country was a Top 5 performer for both 2018 and 2019: the U.S. Last year’s strongest performing market — Finland — ranked 22nd this year through the end of October.

Among emerging markets, Greece swung from a 37% decline last year to more than a 37% advance for the 2019.

Graph: Changes in the Ranks Performance of equity markets in 23 developed and 24 emerging economies

PERENNIAL WISDOM

There is no compelling or dependable way to forecast stock and bond movements from historical returns, and 2019 was a case in point. Neither the mainstream prognostications nor media commentators predicted the strong market performances during 2019.

The market’s pricing power works against even those many professional investors who try to outperform through stock picking or market timing. Most will fail. Among mutual funds, for instance, only 18% of U.S. equity mutual funds and 15% of fixed income funds have both survived and outperformed their benchmarks over the past 15 years.3

We believe rather than making investment decisions based on predicting the direction of financial markets, a wiser strategy for successful planning is to hold an allocation of asset classes that focus on systematic and robust drivers of potential returns — structured from great ideas in finance grounded in economic theory and leading academic research.

History shows that capital markets have rewarded long-term investors. Investors broadly diversified across asset classes from around the globe were better positioned to enjoy returns that the markets delivered in 2019. This is true not only this year, but was last year and will be next year. Professional investment management grounded on modern financial science is a timeless approach.

Building wealth for successful retirement is more than successful investing. Tax and asset protection planning are also important. Find a competent CFP wealth planning professional to help you look ahead to retirement with confidence.

1Based on readings from the Conference Board Consumer Confidence Survey and the University of Michigan Index of Consumer Sentiment.

2Markets designated as developed or emerging by MSCI.

3Mutual Fund Landscape 2019 (Dimensional Fund Advisors) for period ending December 31, 2018 from CRSP data, University of Chicago.

7 Smart Planning Ideas for Year-End

The fourth quarter is still an opportunity for some smart tax planning.

1. Remember to maximize retirement saving accounts

If you’ve turned 50, you’re able to make a catch-up contribution of $6,000 in your 401(k) or 403(b) plan. It’s not too late to catch up for 2019—and also make an election for 2020. Also, anyone with earned income can contribute to a traditional IRA.1 Only the tax deductibility of an IRA contribution may be limited. Unfortunately, Roth IRA contributions have income limits—but non-deductible IRA contributions may be converted into a Roth account without tax impact in some instances.

If you’ve not already maxing out your 401k or 403(b) for this year, you can still increase paycheck deferrals in November and December. And in January, you can make an IRA contribution for 2020. Why not do it early and get a faster start on your savings plan?

IRA chart

2. Review your capital gains and losses for the year.

Mutual fund capital gain distributions typically are announced during the fourth quarter, in addition to stock and fund gains and losses you may have from previous trades. After taking distributions into account, what should you do? If you are in the 22% or higher federal tax bracket, “tax-loss harvesting” may make tax sense. You can “harvest” losses in excess of gains but are limited to taking not more than $3,000 in losses in excess of gains in 2019. Losses not used this year can be carried forward indefinitely for tax purposes.

The long-term capital gain tax rate in the two lowest marginal tax brackets (10% and 12%) is 0%. If you have projected taxable income of less than $51,675 for single filers, or $103,350 for married filing jointly (assuming using only standard deductions for those under age 65), you may recognize long gains taxable at a 0% tax rate. Such tax-gain harvesting techniques will seem even smarter when tax rates increase once again.

3. Review potential itemized deductions for 2019.

Surveys indicate that fewer taxpayers itemize because of increased standard deduction. The IRS allows every personal taxpayer to take a standard deduction without itemizing. To benefit from filing a Schedule A for itemized deductions, total deductible items must exceed $12,200 for singles or $24,400 for marrieds. (Some states like New York still have the previous much lower itemized deduction allowances.) Due to the federal state and local tax (SALT) $10,000 deduction limitation, and mortgage interest deduction limitations, the new federal standard deduction applies to nearly 90 percent of taxpayers.

Standard deduction chart

Apart from those few who incur higher insurance premiums and substantial uninsured health-related expenses, one deductible item you can control are charitable contributions. Let’s see how smart planning can leverage contributions for tax savings.

First, contributions are deductible only in the year they are made. So you must make charitable donations by year-end to take them this year. Therefore, donations charged to a credit card before the end of 2019 will count for 2019—even if the credit card bill isn’t paid until 2020. Also, letters with checks must be postmarked in 2019 to count for 2019.

When planning, consider the potential tax-leverage of gifting appreciated securities instead of cash. Gifting $50,000 in publicly traded stocks (or appreciated mutual funds) with a cost of $10,000 could save up to $9,520 in tax ($40,000 X 23.8%); plus, you still receive a charitable deduction. The top marginal tax bracket rate possible for federal long-term capital gains is 23.8%. States like New York can tax up to an additional 8.82%, and not even offer an offsetting federal itemized income tax deduction on Schedule A.

4. Advanced wealth planning: Qualified charitable distributions.

If you are charitably inclined, at least age 70½, and modest itemize deductions, a qualified charitable distribution (QCD) may be a smart solution. A QCD allows tax-free transfers up to $100,000 directly from an IRA to a qualifying charity. Also, a QCD must be completed by December 31st for a given current tax year.

This technique is ideal for those who do not need the income but are required to make a minimum distribution (RMD). The QCD can be made in place of an RMD. It also makes itemizing that deduction unnecessary, and perhaps avoids the need for a Schedule A.

Donating a QCD correctly to a charity not only reduces both adjusted gross income (AGI) and taxable income but may reduce higher Medicare premiums in the future by not crossing $85,000/ $107,000/ $133,500 levels for singles, or $170,000/ $214,000/ $267,000 for couples, potentially saving up to $7,267 a year for higher income couples.

Additionally, due to making a QCD rather than taking RMD may help the AGI fall below $250,000 for a married filing jointly couple or $200,000 for a single individual. In that case, investment income would not be subject to the federal 3.8% Net Investment Income Tax on capital gains. And for some retirees choosing to live a relatively modest lifestyle while also inclined to make substantial charitable gifts, in some cases their Social Security subject to income tax could be reduced in some years.

“LUMP AND CLUMP” TO DUMP TAXES

Proactive income distribution and tax planning before year-end can overcome an inability to itemize charitable deductions in some years due to the federal standard deduction.

Mr. and Mrs. Smith, ages 55 and 54, have these projected itemized deductions for 2019:

Itemized deduction chart

This is less than the standard deduction of $24,400, so no itemized federal tax return would be submitted. (The problem would be worse once the home mortgage is paid off and no interest remains to be deducted, and high New York taxes are capped.)

So what can the Smiths do to save taxes when they don’t make large charitable gifts each year? The technique is to “lump and clump.” Rather than gift $2,500 each year, the Smiths could “lump” four or even more years of charitable donations into a single year! By “clumping” those donations into a special charitable vehicle called a “donor-advisor fund” (DAF), they can make a series of $2,500 annual “grants” to their church or community or other causes.

Projected itemized deductions chart

This is more than the standard deduction of $24,400, so the Smiths are positioned to itemize and gain a true tax savings benefit from charitable contributions that they already planned to make in future years.

Although the Smiths may not be able to make $10,000 charitable contributions every year, by planning carefully in advance, they may “clump” $10,000 one year into a DAF. Thy would receive a tax deduction in 2019 for their entire DAF contribution. After that, the Smiths decide when to make grants and which charities will receive those grants. Meantime, monies are invested, and earnings are tax exempt. Done early in the year, their usual charity could still receive the $2,500 they planned on by the end of 2019.

Contributions to DAFs are not limited to $10,000 or even $100,000. For those who desire to make a big impact in their church, community or causes they care deeply about, and have an extraordinary income event in a given year (say from an employer bonus, exercise of stock options, or even the sale of a company), DAFs offer an exceptional opportunity to magnify your charitable giving without committing to any particular charity or timeframe for payout in advance.

Special note for greater tax savings: Donor Advised Funds accept appreciated securities as well as cash. Selling appreciated public shares contributed to a DAF has no tax impact.2

Donor Advised Funds chart

5. If you plan gifts to family or friends, do it by year end so you can give again next year.

You can give up to $15,000 to anyone and to any number of people without filing a gifttax return. If recipients have lower income than you, consider gifting highly appreciated securities, which removes the gain from your portfolio. Recipients with lower income will pay less tax on sale and they may even qualify for a 0% federal capital gain rate.

Don’t gift portfolio losers; you need them to offset your own gains, and donees won’t benefit from your loss position, but instead assume the lower value as their tax basis.

6. Don’t forget that today’s tax brackets are only lower temporarily.

Take advantage of current lower federal tax rates and consider the benefit of Roth conversions this year and in successive years while brackets remain low. Roth conversions are not necessarily costly. Pairing tax strategies can mitigate tax impact. For instance, charitable contributions to a DAF for 2019 could be matched to a Roth conversion. If a passive activity with suspended losses from a commercial property sale is unsuspended—a Roth conversion is a smart way to utilize those phantom losses. Unlike earnings limitations on annual Roth contributions, Roth conversions have no limits.

7. Why pay more tax now when you could pay less tax later?

Smart tax planning generally accelerates deductions and defers realizing income. While most income and expense may be beyond your control, some things offer you a choice. Consider deferring income from bonuses, consulting, self-employment or realizing capital gains—and taking advantage of IRAs and qualified plans. For deductions, you may be able accelerate charitable contributions, state income and property taxes, and sometimes interest payments.

Tax planning is not only a year-end exercise. For greater tax savings and higher net returns, find a competent CPA or CFP wealth management professional with experience in tax planning to mitigate the impact of taxes and so magnify your wealth outcomes.

1Traditional IRA Limitations Source: See IRS Publication 590. Those over age 70 cannot contribute.

2Please note that charitable substantiation requirements apply per IRA pub 1771: “A donor can deduct a charitable contribution of $250 or more only if the donor has a written acknowledgment from the charitable organization.” The donor must get the acknowledgement by the earlier of the date the donor files the original return for the year the contribution is made, or the due date, including extensions, for filing the return.

Please note that (i) any discussion of U.S. tax matters contained in this communication cannot be used by you for the purpose of avoiding tax penalties; (ii) this communication was written to support the promotion or marketing of the matters addressed herein; and (iii) you should seek advice based on your particular circumstances from an independent tax advisor.

Recent U.S. Stock Market Volatility

While recent volatility of American stock markets may worry some investors, market declines are a normal part of investing and part of the reason why stocks have a higher expected return than other investments.

Stock market declines in July and August, following last year’s losses in the last quarter of 2018 has renewed anxiety for some investors. While the media focuses a great deal of attention on daily price declines, volatility is simply a normal part of investing and a big part of the “risk” that “rewards” long-term investors in global markets. In the video link below, Nobel laurate Eugene Fama remarks that if “you have a long horizon over which you are going to be invested, then you don’t want to pay attention to the short-term.”

For investors who react emotionally during volatile markets — often inspired by increased media reporting and paying too much attention — timing the wrong response may be far more detrimental to their long-term results than any short-term drawdown impact.

INTRA-YEAR DECLINES ARE COMMON

Exhibit 1 shows calendar year returns for the US stock market since 1979, as well as the largest intra-year gains and declines that occurred during a given year. During this period, the average intra-year decline was about 14%. About half of the years observed had declines of more than 10%, and around a third had declines of more than 15%. Despite substantial intra-year drops during several years, calendar year returns were positive in 33 years out of the 40 examined. This exhibit shows just how common market declines are. Moreover, it also shows just how difficult it is to say whether a large intrayear decline that happens to occur will result in negative returns over the entire calendar year.

In US dollars. US Market is the Russell 3000 Index. Largest Intra-Year Gain refers to the largest market increase from trough to peak during the year. Largest Intra-Year Decline refers to the largest market decrease from peak to trough during the year. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Data is calculated off rounded daily returns.

REACTING CAN NEGATIVELY IMPACT RESULTS

If you tried to time the market in order to avoid potential losses associated with periods of increased volatility, how much would this help or hinder your long-term performance? If current market prices aggregate the information and expectations of all market participants, then timing cannot systematically exploit stock mispricing. In other words, it is unlikely that many investors will successfully time the market, and when they do manage it, usually it is a result of luck rather than skill.

Further complicating the prospect of market timing being potentially additive to portfolio performance is the fact that a hugely disproportionate amount of total stock returns occurs during just a handful of days. Since few, if any, investors can reliably predict in advance which days will have strong returns and which will not, the prudent course is to remain invested during periods of volatility rather than move into and out of cash. Otherwise, an investor risks holding cash on those few days when returns become strongly positive.

In US dollars. For illustrative purposes. The missed best day(s) examples assume that the hypothetical portfolio fully divested its holdings at the end of the day before the missed best day(s), held cash for the missed best day(s), and reinvested the entire portfolio in the S&P 500 at the end of the missed best day(s). Annualized returns for the missed best day(s) were calculated by substituting actual returns for the missed best day(s) with zero. S&P data © 2019 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. “One-Month US T- Bills” is the IA SBBI US 30 Day TBill TR USD,
provided by Ibbotson Associates via Morningstar Direct. Data is calculated off rounded daily index values.

Exhibit 2 helps illustrate this point. It shows the annualized compound return of the S&P 500 Index for 29 years beginning in 1990. It also illustrates the impact of missing out on just a few days with the strongest returns during all those years. The bars represent the hypothetical growth of $1,000 over the period — and what is lost by missing the best 1 day, best 5 days, best 15 days and best 25 days. The data shows that avoiding equity allocations for only a few of the best single days in the market would have resulted in substantially lower returns than the total period had to offer — in fact, if you missed the best 30 days of that 29-year period, the realized return from such an equity investing strategy only would be equivalent to risk-free one-month US T-bills!

CONCLUSION

While market volatility can be stressful for some investors, reacting emotionally and changing a sound long-term investment strategy in response to short-term declines lasting even a year or more could prove far more harmful than helpful. By adhering to a professionally developed investment management process, with an investment policy agreed upon in advance of volatile times describing the potential ranges of potential declines, investors may be better able to stay disciplined during those inevitable periods of short-term uncertainty. Conversations with a CFP® professional may help.

In a bit of practical advice, Professor Fama admonishes below: “You’re better off if you just don’t look. Basically, don’t pay a lot of attention to what is going on in the markets.”

When markets are messy and he’s not doing research or writing, Gene is known to go out and play golf or tennis. Maybe you should too.

still frame and link to video, "How Risk Tolerant Are You" by Eugene Fama

IPOs: Profiles Are High. What About Returns? – August 2019

Initial public offerings (IPOs) often attract initial public interest — especially when familiar brands become broadly available to investors for the first time.

In recent months, investors have had the opportunity to buy shares of ride‑hailing networks Uber and Lyft, workplace productivity services Zoom and Slack, and other high-profile businesses ranging from Pinterest to Beyond Meat.

News outlets contribute to the frenzy, building anticipation, tracking the early hours of trading, and casting judgment on the IPO’s success. Investors, perhaps lured by tales of outsized returns, try to get in on the action early.

New Dimensional research reveals the fundamental challenges IPO investors face. They may not be able to trade during the early hours, when the biggest price movements frequently occur. Lockup periods also often restrict when shares held by early investors can be resold on secondary markets, which can meaningfully limit the available liquidity in the first six to 12 months after an IPO. And medium‑term IPO performance is often underwhelming.

Dimensional’s Research team studied the first-year performance of more than 6,000 US IPOs from 1991 to 2018 and found they generally underperformed industry benchmarks. The researchers also found that known drivers of expected returns largely explain that underperformance.

SHORT-TERM IPO RETURNS

IPOs are commonly associated with outsized stock returns on the first day shares become available, although these returns may not be attainable by all investors due to the allocation process. Researchers have shown that initial trading prices typically exceed the IPO offering price.1 However, accessing these first-day returns requires an allocation from the underwriting banks. Studies have documented an adverse selection problem associated with IPO share allocations and find that allocations to IPOs having poor first-day returns have generally been easier to obtain, while allocations to IPOs with good first‑day returns have usually been reserved for certain clients of the underwriting banks.2

MEDIUM-TERM IPO RETURNS

Given that many investors may not be able to access these initial returns, Dimensional focused on the performance of IPOs in the secondary market. How do IPOs perform in their first year?

The sample for Dimensional’s study consists of 6,362 US IPOs that occurred from January 1991 to December 2018 and for which data is available.3 Exhibit 1 shows the annual frequency and market cap distribution of IPOs among firm size groups. The period from 1991 to 2000 is characterized by a relatively high IPO frequency rate of 420 per year and is followed by a less active 18-year period during which the rate falls to 120 IPOs on average per year. Although the number of IPOs has declined, the average IPO offering size is almost three times larger over the most recent period, as compared to the initial 10 years in the sample.

Most IPOs fall into the small cap size group, defined as firms that fall below the largest 1,000 US‑domiciled common stocks at the most recent month‑end. Large cap and mid cap IPOs represent 24% and 19%, respectively, of total capital raised through IPOs over the sample period.

Source: Dimensional using Bloomberg data. The sample includes US market IPOs, including US-domiciled companies and foreign-domiciled IPOs in the US, with an offering date between January 1, 1991, to December 31, 2018. Excluded from the sample are IPOs with an offer price below $5, unit IPOs (common stock and warrants), and IPOs involving real estate investment trusts, closed-end funds, American depository receipts, partnerships, and acquisition companies. IPO categories (small, mid, and large) are based on market cap rank relative to all US-domiciled common stocks as of the most recent month-end. Large, mid, and small cap are defined as firms that rank in the top 500, 501–1,000, and >1,000 by market value, respectively.

IPO PERFORMANCE

Dimensional evaluated IPO returns by forming a hypothetical market cap-weighted portfolio consisting of IPOs issued over the preceding 12-month period, rebalanced monthly.4 This methodology excludes the initial first-day returns by design to alleviate the adverse selection problem inherent in the IPO allocation process.
Exhibit 2 compares the returns of the IPOs to the returns of the Russell 2000 and 3000 indices over the full sample period as well as two subperiods covering 1992–2000 and 2001–2018. IPOs underperform the Russell 3000 Index in both the overall period and sub-sample periods. For example, IPOs generate an annualized compound return of 6.93%, 13.63%, and 3.74% over the full, initial nine-year and final 18-year sample periods, respectively, as compared to 9.13%, 15.70%, and 5.98% for the Russell 3000 index over the same time horizons. In comparison to the Russell 2000 Index, the hypothetical portfolio of IPOs underperform in the overall period (6.93% vs. 9.02%) and the 2001–2018 (3.74% vs. 7.29%) subperiod and outperform (13.63% vs. 12.56%) over the period from 1992 to 2000.

Known drivers of returns largely explain the underperformance of IPOs. That means, there is no “free lunch” for playing this kind of financial lottery. IPOs have underperformed the market because, as a group, they have behaved like small growth, low profitability, high investment stocks, which have had lower expected returns than the market.5

IPO Activity graph #2

Past performance does not guarantee future results.

Source: Dimensional using Bloomberg data. The sample includes US market IPOs, including US-domiciled companies and foreign-domiciled IPOs in the US, with an offering date between January 1, 1991, to December 31, 2018. Excluded from the sample are IPOs with an offer price below $5, unit IPOs (common stock and warrants), and IPOs involving real estate investment trusts, closed-end funds, American depository receipts, partnerships, and acquisition companies. The hypothetical IPO portfolio is formed December 31, 1991, and is rebalanced monthly to include all firms with an IPO during the prior 12-month period. Weights are based on prior month-end market capitalization. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indices. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

SUMMARY

IPOs have enormous adverse selection and frequently harmful post-offering activities. The market, and market prices, respond far faster than you ever will to erase possible profits. Since risky IPOs generally underperform simply holding the broad market with an index fund, no informed non-institutional investor should get involved. Many people dream about getting rich with IPOs. We recommend planning strategies based on the science of capital markets, with a professional process where decades of research guide the way. Our goal is to deliver an outstanding planning experience for clients. We help disciplined clients who diligently follow their plan, live the dream. They don’t need IPOs.

REFERENCES

  • Black, Stanley and Kevin Green. 2019. “What to Know About an IPO.” Research Matters: 3.
  • Bradley, Daniel, Bradford Jordan, and Ivan Roten. 2001. “Venture Capital and IPO Lockup Expiration: An Empirical Analysis.” Journal of Financial Research 24: 465–493.
  • Brav, Alon and Paul Gompers. 2003. “The Role of Lockups in Initial Public Offerings.” The Review of Financial Studies 16: 1–29.
  • Ellis, Katrina, Roni Michaely, and Maureen O’Hara. 2000. “When the Underwriter Is the Market Maker: An Examination of Trading in the IPO Aftermarket.” The Journal of Finance 55: 1039–1074.
  • Fama, Eugene, and Kenneth French. 2015. “A Five-Factor Asset Pricing Model.” Journal of Financial Economics 116: 1–22.
  • Field, Laura and Gordon Hanka. 2001. “The Expiration of IPO Share Lockups.” The Journal of Finance 56: 471–500.
  • Hanley, Kathleen, A. Arun Kumar, and Paul Seguin. 1993. “Price stabilization in the market for new issues.” Journal of Financial Economics 34: 177–197.
  • Jenkinson, Tim, Howard Jones, and Felix Suntheim. 2018. “Quid Pro Quo? What Factors Influence IPO Allocations to Investors?” The Journal of Finance 73: 2303–2341.
  • Reuter, Jonathan. 2006. “Are IPO Allocations for Sale? Evidence from Mutual Funds.” The Journal of Finance 61: 2289–2324.
  • Ritter, Jay. 1987. “The Costs of Going Public.” Journal of Financial Economics 19: 269–281.

NOTES

  • 1Ritter, Jay. 1987. “The Costs of Going Public.” Journal of Financial Economics 19: 269-281.
  • 2Reuter, Jonathan. 2006. “Are IPO Allocations for Sale? Evidence from Mutual Funds.” The Journal of Finance 61: 2289-2324; Jenkinson, Tim, Howard Jones, and Felix Suntheim. 2018. “Quid Pro Quo? What Factors Influence IPO Allocations to Investors?” The Journal of Finance 73: 2303 -2341.
  • 3Dimensional mirrors the traditional empirical research approach to analyze US IPOs by excluding the following: IPOs with an offer price below $5, unit IPOs (common stock and warrants), and IPOs involving real estate investment trusts, closed-end funds, American depository receipts, partnerships, and acquisition companies.
  • 4Market cap figures are based on Bloomberg data that exclude shares subject to IPO lockup agreements.
  • 5Black, Stanley and Kevin Green. 2019. “What to Know About an IPO.” Research Matters: 3.

Timing Isn’t Everything – July 2019

Over the course of a summer, it’s not unusual for the stock market to be a topic of conversation at barbecues or other social gatherings. A neighbor or relative might be asking about which investments are especially good at the moment. The lure of getting in at the right time or avoiding the next downturn may tempt even disciplined, long-term investors to take action. The reality of successfully timing markets, however, isn’t nearly as straightforward as it sounds.

OUTGUESSING THE MARKET IS DIFFICULT

Attempting to buy individual stocks or make tactical asset allocation changes at exactly the “right” time presents investors with formidable challenges. First and foremost, markets are fiercely competitive and highly adept at processing information. During 2018, a daily average of $462.8 billion in equity trading took place around the world.1 The combined effect of all this buying and selling is that available information, from economic data to investor preferences and so on, is quickly incorporated into security market prices. Trying to time the market based on an article from this morning’s newspaper or a segment from financial television? It’s likely that information is already reflected in prices by the time you can react to it.

Dimensional Fund Advisors once again studied the performance of actively managed mutual funds over twenty years and found that even professional investors have difficulty beating the market: over the last 20 years, 77% of equity funds and 92% of fixed income funds failed to survive and outperform their benchmarks after costs.2

Further complicating matters, for investors to have a shot at successfully timing the market, they must make the correct call to buy or sell stocks not just once, but twice. Professor Robert Merton, a Nobel laureate, said it well in a recent interview with Dimensional:

“Timing markets is the dream of everybody. Suppose I could verify that I’m a .700 hitter in calling market turns. That’s pretty good; you’d hire me right away. But to be a good market timer, you’ve got to do it twice. What if the chances of me getting it right twice were independent each time? They’re not. But if they were, that’s 0.7 times 0.7. That’s less than 50-50. So, successful market timing is horribly difficult to do.”

TIME AND THE MARKET

The S&P 500 Index has logged an astonishing ten-year performance. Should this result suggest reducing normal investment policy allocations for U.S. stocks? Exhibit 1 suggests that new market highs have not been harbingers of poor outcomes longer term. Historic data shows positive average annualized returns over one, three, and five years following new market highs, not only in the U. S. but in most developed markets internationally where that occurs.

In US dollars. Past performance is no guarantee of future results. New market highs are defined as months ending with the market above all previous levels for the sample period. Annualized compound returns are computed for the relevant time periods subsequent to new market highs and averaged across all new market high observations. There were 1,115 observation months in the sample. January 1990–present: S&P 500 Total Returns Index. S&P data © 2019 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. January 1926–December 1989; S&P 500 Total Return Index, Stocks, Bonds, Bills and Inflation Yearbook™, Ibbotson Associates, Chicago. For illustrative purposes only. Index is not available for direct investment; therefore, its performance does not reflect the expenses associated with the management of an actual portfolio. There is always a risk that an investor may lose money.

CONCLUSION

Outguessing markets is far more difficult and riskier than popularly believed. While successful timing is theoretically possible, research finds little evidence that even professionals can do it reliably. The good news is that smart investors don’t need to practice clever timing for investing success. Capital markets have rewarded long-term disciplined and informed investors who maintained intelligent equity exposures despite periods of price volatility. By positioning and focusing on what you can control (like appropriate asset allocation, broad diversification, and managing expenses, turnover, and taxes), through professional wealth management you may take advantage of what capital markets can provide and experience more peace of mind.

  • 1In US dollars. Source: Dimensional Fund Advisors, using data from Bloomberg LP. Includes primary and secondary exchange trading volume globally for equities. ETFs and funds are excluded. Daily averages were computed by calculating the trading volume of each stock daily as the closing price multiplied by shares traded that day. All such trading volume is summed up and divided by 252 as an approximate number of annual trading days.
  • 2Mutual Fund Landscape 2019, Dimensional Fund Advisors Publication (2019).

Will Index Investing Make Investors Worse Off?

Many commentators claim that the increased popularity of index funds somehow distorts market prices. Their argument premises that indexing reduces the “efficiency” of price discovery. But should increasing use of index funds really concern investors?

The acceptance of index funds for the portfolio strategy of many investors has received much attention in the financial media. Can index funds become so popular that future expected returns could be worse simply due to “blindly” buying and selling the underlying holdings of a commercial index like the S&P 500? The argument is that due to a rigid process used by “too many” investors, sufficient price discovery may not occur so price “inefficiencies” may occur in financial markets. Using data and reasoning, we can examine this claim to show that markets still work, and that investors can rely on market prices for planning portfolios.

MANY BUYERS AND SELLERS

While the popularity of indexing has increased substantially, index fund investors still make up only a modest percentage of investing overall. Data from the Investment Company Institute1 shows that as of December 2017, 35% of total net assets in US mutual funds and ETFs were held by index funds, compared to 15% in December of 2007, an increase well over 100 percent. Nevertheless in 2017 most total fund assets (65%) were still managed by active mutual funds. When the entire securities market is considered, the percentage of index-based mutual funds and ETFs is relatively small even today. As shown in Exhibit 1, domestic index mutual funds and ETFs comprised only 13% of total US stock market capitalization in 2017

Exhibit 1

Exhibit 1 graphic

Exhibit 1. Investor Breakdown in the US Stock Market as a Percentage of Total US Stock Market Capitalization

All totals may not equal 100% due to rounding. Sourced from the ICI Fact Book

It should be observed that many investors use nominally “passive” index ETF vehicles to engage in conventional “active” trading. For example, while both a value index ETF and growth index ETF may be technically classified as “index” vehicles, yet many investors actively trade monthly, daily and hourly between these funds and other ETF indexes with different objectives based on short-term expectations, needs, circumstances, or for speculation. In fact, several index ETFs regularly rank among the most actively traded securities.

Beyond traditional actively managed mutual fund vehicles there are many other market participants who actively buy and sell individual securities. These include actively managed pension funds, hedge funds, and insurance companies, just to name a few. Security prices reflect the viewpoints of all these participating investors, as well as those of mutual funds and ETFs.

Professors Eugene Fama and Kenneth French rhetorically asked the question in a blog post titled “Q&A: What if Everybody Indexed?” They explained that the informational impact of an increase in indexed assets depends to some extent on which market participants switch to indexing:

“If misinformed and uninformed active investors (who make prices less efficient) turn passive, the efficiency of prices improves. If some informed active investors turn passive, prices tend to become less efficient. But the effect can be small if there is sufficient competition among remaining informed active investors. The answer also depends on the costs of uncovering and evaluating relevant knowable information. If the costs are low, then not much active investing is needed to get efficient prices.” 2

Exhibit2 chart illustration

Exhibit 2. Annual Global Equity Market Trading Volume, 2007–2018

In US dollars. Source: Dimensional, using data from Bloomberg LP. Includes primary and secondary exchange trading volume globally for equities. ETFs and funds are excluded. Includes 2017 total returns for constituent securities in the S&P 500 Index as of December 31, 2016. Excludes securities that delisted or were acquired during the year. Source: S&P data ©2019 S&P Dow Jones Indices LLC, a division of S&P Global. For illustrative purposes only. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

THE IMPACT OF VOLUME

Trade volume data provides more evidence of how well markets continue to function even while the level of indexing has increased. Exhibit 2 shows that despite an increasing movement toward passive index funds, equity market trading volumes have remained at similar levels over the past 10 years. This indicates that markets globally still function well enough to facilitate large scale price discovery.

In addition to secondary market trading, other paths incorporate new information into market prices. For example, companies themselves can impact their share prices simply by issuing stock and repurchasing shares. In 2018 alone, there were 1,633 initial public offerings, 3,492 seasoned equity offerings, and 4,148 buybacks around the world.3 The derivatives markets also incorporate new information into market prices: the prices of those financial instruments are linked to the prices of underlying equities and bonds. On an average day in 2018, market participants traded over 1.5 million options contracts and $225 billion worth of equity futures.3

HYPOTHESIS IN PRACTICE

Even though historical evidence suggests that increased levels of indexing is unlikely to distort market prices, let’s consider a counterargument: does increased indexing distort available market information and in turn cause prices to become less reliable? In this case, wouldn’t we expect to see stock-picking managers who claim to capture mispricing of securities have more and more success over the years as an increasing proportion of shares are indexed each year?

Exhibit 3 chart illustration

Exhibit 3. Annual Global Equity Market Trading Volume, 2007–2018

Equity mutual fund outperformance percentages are shown for the three-year periods ending December 31 of each year, 2004–2018. Each sample includes equity funds available at the beginning of the three-year period. Outperformers are funds with return observations for every month of the three-year period whose cumulative net return over the period exceeded that of their respective Morningstar category index as of the start of the period. US-domiciled non-Dimensional mutual fund data is from Morningstar. Dimensional fund data provided by the fund accountant. Past performance is no guarantee of future results.

Exhibit 3 shows little evidence to support that assertion. If anything, it suggests the opposite. This chart shows the percentage of active managers that both survive and beat their benchmarks over rolling three-year periods. These data show no strong evidence linking the percentage of indexed equity mutual fund assets to the percentage of actively managed funds successfully outperforming the relative benchmark indices.

Lastly, in a world where a large proportion of index funds could bias prices, we should expect to see some evidence across the holdings of mega index funds. That is, there should be increased uniformity in the relative returns for securities held within the same index as inflows drive prices up among stocks (and outflows drive prices down). The S&P 500 is a widely tracked index with over $9.9 trillion USD indexed or benchmarked to the index and with indexed assets comprise approximately $3.4 trillion USD of this total.4 The S&P 500 Index, however, does not evidence this.

Exhibit 4 shows that in 2008, the first year of the global financial crisis, a year of large net outflows with a negative index return of –37.0%, the returns of underlying individual stocks ranged from 39% to –97%. In 2017, a year with very large net inflows and a positive index return of 21.8%, the constituent returns ranged from 133.7% to –50.3%. Moreover, we would expect that stocks with similar weighting within a conventional market cap-weighted indices would share similar returns. Yet in 2017, Amazon and General Electric returned 56.0% and –42.9%, respectively, despite each accounting for approximately 1.5% of the S&P 500 Index.

Exhibit 4 chart illustration

Exhibit 4. Range of S&P 500 Index Constituent Returns

Upper chart includes 2008 total returns for constituent securities in the S&P 500 Index as of December 31, 2007. Lower chart includes 2017 total returns for constituent securities in the S&P 500 Index as of December 31, 2016. Excludes securities that delisted or were acquired during the year. Source: S&P data ©2019 S&P Dow Jones Indices LLC, a division of S&P Global. For illustrative purposes only. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

CONCLUSION

Despite the greatly increased popularity of index-based mutual funds and ETFs, empirical data continue to support the academic notion that informational efficiency of markets works. Annual trading volume has not reduced over the years, so that an enormous volume of market transactions still drives price discovery. Active mutual fund managers continue to underperform by as much as they always have, suggesting that increased indexing makes outguessing the market no easier. Prices of individual holdings within major indices don’t move in lockstep with index fund asset flows. Lastly, while naysayers keep suggesting the “hidden danger” of indexing, the reality is that holdings of index funds are still only a small percentage of the total global investable market.

Investors should be confident that public markets function well; willing buyers and sellers still meet and agree upon prices at which they desire to transact. While indexing has been a great financial innovation, it is only one solution in a universe of alternatives. To become more informed about the possible solutions and strategies, contact a CFP® wealth management professional.

GLOSSARY

  • Derivative: A financial instrument whose value is based on an underlying asset or security.
  • Options Contract: An options contract is an agreement between two parties to facilitate a potential transaction on an underlying security at a preset price.
  • Futures: A financial contract obligating the buyer to purchase an asset or a seller to sell an asset at a predetermined future time and price.

  • 1ici.org/pdf/2018_factbook.pdf
  • 2famafrench.dimensional.com/questions-answers/qa-what-if-everybody-indexed.aspx
  • 3Options, futures, and corporate action data are from Bloomberg LP. Options contact volume is the sum of the 2018 daily average put and call volume of options on the S&P 500 Index, Russell 2000 Index, MSCI EAFE Index, and MSCI Emerging Markets Index. Equity futures volume is equal to total 2018 futures volume traded divided by 252, where annual volume traded is estimated as the sum of monthly volume times month-end contract value for S&P 500 Mini futures, Russell 2000 Mini futures, MSCI EAFE Mini futures, and MSCI Emerging Markets Mini futures. IPO, seasoned equity offering, and share repurchase data are based on Bloomberg corporate actions data and include countries that are eligible for Dimensional investment.
  • 4Source: S&P Dow Jones.

The Unexpected in Average Returns

“I have found that the importance of having an investment philosophy — one that is robust and that you can stick with — cannot be overstated.” –David Booth, former CEO and Founder, Dimensional Fund Advisors

The US stock market has delivered an average annual return of around 10% since 1926. But short-term results vary widely, and in any given period stock returns can be positive, negative, or flat. When thinking about what to expect, it’s helpful to see the historical range of outcomes experienced by investors. How often have the stock market’s annual returns actually aligned with its long-term average? Rarely.

Exhibit 1 shows calendar year returns for the S&P 500 Index since 1926.1 The shaded band marks the historical average of 10%, plus or minus 2 percentage points. The S&P 500 Index had a return within this range in only six of the past 93 calendar years. In most years, the index’s return was outside of the range — often above or below by a wide margin — with no obvious pattern. For investors, this data highlights the importance of looking beyond the “average” and being aware of a huge range of possible outcomes.

Exhibit 1. S&P 500 Index Annual Returns 1926–2018

Graphic, Exhibit 1 - S&P 500 Index Annual Returns 1926–2018

In US dollars. S&P data © S&P Dow Jones Indices LLC, a division of S&P Global. Indices are not available for direct investment. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Past performance is no guarantee of future results. Actual returns may be lower.

TUNING IN TO DIFFERENT FREQUENCIES

Despite the year-to-year volatility, investors may increase their chances of positive outcomes if they maintain a long-term focus. Exhibit 2 documents the historical frequency of positive returns over rolling periods of one, five, and 10 years in the US market. The data show that, while positive performance is never assured, investors’ odds improve dramatically over longer time horizons.

Exhibit 2. Frequency of Positive Returns in the S&P 500 Index Overlapping Periods: 1926–2018

graphic - Exhibit 2. Frequency of Positive Returns in the S&P 500 Index Overlapping Periods: 1926–2018

In US dollars. From January 1926–December 2018, there are 997 overlapping 10-year periods, 1,057 overlapping 5-year periods, and 1,105 overlapping 1-year periods. The first period starts in January 1926, the second period starts in February 1926, the third in March 1926, and so on. S&P data © S&P Dow Jones Indices LLC, a division of S&P Global. Indices are not available for direct investment. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Past performance is no guarantee of future results. Actual returns may be lower.

CONCLUSION

Most investors might find it easy to stay the course in years with above average returns. Disappointing periods will test your philosophy or approach for equity investing. Being aware of the normal range of possible outcomes can help investors remain disciplined. Being disciplined increases the odds of having a successful investment experience.

What helps investors better endure inevitable market ups and downs? First, understanding how markets work and having a belief that market prices are fair are a good start. Next, having a scientific investing strategy using sensible global asset classes and not being concentrated only in U.S. large stocks. Then having an investment policy that aligns risk with your true personal preferences and wealth planning goals.

By understanding what matters and working with an experienced CFP® wealth management professional, you will be better positioned for a more reliable retirement outcome with more confidence during whatever troubled markets and times are yet to come.

1As measured by the S&P 500 Index from 1926–2018.

Getting to the Point of a Point

While the Dow and other indices are popularly interpreted as indicators of broader stock market performance, the stocks composing these indices may not represent an investor’s actual portfolio or strategy.

A quick online search for “Dow rallies 500 points” yields a cascade of news stories with similar titles, as does a similar search for “Dow drops 500 points.” These types of headlines may make little sense to many investors, given that a “point” for the Dow and what it means for their own portfolios is unclear. The potential for misunderstanding also exists among even experienced market participants. Given that index levels have risen over time, potential emotional anchors such as a 500-point move do not have the same impact on performance as they used to. With this in mind, let’s consider what a point move in the Dow means and its impact on an hypothetical investment portfolio.

IMPACT OF INDEX CONSTRUCTION

The Dow Jones Industrial Average was first calculated in 1896 and currently consists of 30 large cap US stocks. The Dow is a price-weighted index, which is different than more common market capitalization-weighted indices like the S&P and Russell indexes.1 An example may help put this weighting methodology difference in perspective. Consider two companies that have a total market capitalization of $1,000. Company A has 1,000 shares outstanding that trade at $1 each, and Company B has 100 shares outstanding that trade at $10 each. In a market capitalization-weighted index, both companies would have the same weight since their total market caps are the same. However, in a price-weighted index, Company B would have a larger weight due to its higher stock price. This means that changes in Company B’s stock would be more impactful to a price-weighted index than they would be to a market cap-weighted index. The relative advantages and disadvantages of these methodologies are another topic, but our purpose of discussing these differences is to point out that design choices can have a large impact on index performance figures. Investors should be aware of this impact when comparing their own portfolios’ performance to a particular index.

HEADLINES VS. REALITY

Movements in the Dow are often communicated in units known as points, which signify the level of index change. Because of this different methodology, investors should be cautious when interpreting headlines that reference point movements. A move of, say, 500 points in either direction is much less meaningful today than in the past largely because the overall index level is much higher today than it was many years ago. Exhibit 1 plots the magnitude of this decline in percentage terms over time. A 500-point drop in January 1985, when the Dow was near 1,300, equated to a nearly 39% loss. A 500-point drop in December 2003, when the Dow was near 10,000, meant a much smaller 5% decline in value. And a 500-point drop in early December 2018, when the Dow hovered near 25,000, resulted in only a 2% loss.

Dow Jones and S&P 500 data © 2019 S&P Dow Jones Indices LLC, a division of S&P Global. The chart illustrates what a 500-point drop would have been in percentage terms for the Dow Jones Industrial Average on a daily basis. It assumes a 500-point loss took place each trading day from January 1, 1985, to February 1, 2019, and uses daily historical closing values of the Dow Jones Industrial Average to compute the percentage change. Percentage change does not indicate the actual change in the Dow during the period shown. Actual results may vary.

The chart illustrates what a 500-point drop would have been in percentage terms for the Dow Jones Industrial Average on a daily basis. It assumes a 500-point loss took place each trading day from January 1, 1985, to February 1, 2019, and uses daily historical closing values of the Dow Jones Industrial Average to compute the percentage change. Percentage change does not indicate the actual change in the Dow during the period shown. Actual results may vary.

HOW DOES THE DOW RELATE TO YOUR PORTFOLIO?

Furthermore, while the Dow and other indices are interpreted by the media as indicators of broad stock market performance, the stocks composing these indices do not represent what may be a globally diversified portfolio even if entirely in equities. For context, the MSCI All Country World Investable Market Index (MSCI ACWI IMI) covers just over 8,700 large, mid, and small cap stocks in 23 developed and 24 emerging markets countries with a combined market cap of more than $50 trillion. The S&P 500 includes 505 large cap US stocks with approximately $23.8 trillion in combined market cap.2 The Dow is a collection of 30 large cap US stocks with a combined market cap of approximately $6.8 trillion.3

Even though the MSCI ACWI IMI, S&P 500, and Dow are all stock market indices, each one tracks different segments of the market, so their performance can differ significantly over time, as shown in Exhibit 2. Since 1995, the Dow has outperformed the S&P 500 and MSCI ACWI IMI by an average of 0.5% and 3.3%, respectively (based on calendar year returns). However, relative performance in individual years can be much different. For example, in 1997, the Dow underperformed the S&P 500 by 8.4% but outperformed the MSCI ACWI IMI by 13.9%.

Performance of MSCI ACWI IMI, S&P 500, and Dow by Calendar Year Dow Jones and S&P 500 data © 2019 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. MSCI data © MSCI 2019, all rights reserved.

MSCI ACWI IMI is the MSCI All Country World Investable Market Index (net dividends). Their performance does not reflect fees and expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results. It is also important to note those planning long-term investment management strategies are concerned about other asset classes besides stocks. Depending on investor needs, a professionally diversified portfolio targeted toward the risk preferences, risk capacity and risk adhesion of a family a will often include a mix of global stocks, bonds, commodities, and any number of other assets not represented in a commercial stock index. A portfolio’s performance should always be evaluated within the context of an investor’s specific goals and time horizons for planning. Understanding how a personal portfolio compares to broadly published indices like the Dow can give investors context about how headlines apply to their own situation—or when comparing portfolios with a friend or colleague. An acute case of “returns envy” can often result in disappointment or even disaster if a sound strategy is abandoned simply to out-perform a neighbor.

CONCLUSION

News headlines are written to grab your attention. A headline publicizing a 500-point move in the Dow is intended to trigger an emotional response and, depending on the direction, will sound either exciting or ominous enough to warrant reading the article. However, for serious wealth management, attention-getting headlines rarely offer practical insight for achieving reliable planning outcomes, especially for those investors with a philosophy based on modern financial science and a strategy integrated with their individual goals, needs, and preferences in a broadly diversified and cost-effective manner.

1Market capitalization is the product of price and shares outstanding.

2500 companies are included in the S&P 500 Index. However, because some of these companies have multiple classes of stock that meet the requirements for inclusion, the total number of stocks tracked by the index is 505.

3Market cap data as of January 31, 2019.