A Modest Plea for a Better Index


For most investors, the stock market, as they know it, is the Dow Jones (INDEX: ^DJI) and the S&P 500 (INDEX: ^GSPC) . For the media, the two represent everything. How's the market doing? Better cite the Dow or the S&P.

It's unfortunate, really. Both indexes that we've come to obsess over have flaws. The Dow weights its components by share price, giving IBM (NYS: IBM) 22 times the weight of Bank of America (NYS: BAC) . No one I know has ever rationalized this practice. The S&P is weighted by market cap, which makes more sense, but often skews it toward the market's most overvalued companies.

Yet, both share a more glaring defect: They don't include dividends.

Let's cut to the chase. There's no better way to put it than this:

Source: Yale, author's calculations.

We fixate over how much the market indexes have gone up or down in the last month, year, or decade. But since the S&P 500 was created in 1957, one-third of average annual returns have come from dividends. Assuming dividends are reinvested, rising market prices on shares purchased with dividend proceeds means 82% of the market's cumulative return is the result of reinvested dividends. Why would we ignore that? It's the equivalent of measuring how much your child has grown while ignoring everything from the neck down.

It wasn't always this way. Classic investment books written in the early 20th century emphasize dividends as the driver of stock returns. The 1931 book Only Yesterday provides the most telling example. When the author, Frederick Lewis Allen, writes about stock prices, he includes the annual dividend payment in parenthesis next to the share price -- "American Can ($2) $77." That was the standard notation of the day.

Attitudes toward dividends changed in a big way starting around the 1980s. As trading costs plunged after brokerage deregulation in 1975, investors, for the first time, could legitimately become short-term traders. As time horizons shrank, so did the importance of dividends, because their value lies in long-term compounding. By 2000, dividends were a sideshow. One Standard & Poor's study on dividend payments that year begins by admitting, "Though currently not a hot topic...."

But ignoring dividends, when measuring market returns, leads to of all kinds of misconceptions. Like the idea that the market suffered a lost decade from 2000 to 2010, when it actually returned 20% after dividends. Or the notion that the market was flat from 1968 to 1982, when it nearly doubled, with dividends.

Here's what's baffling. Both the Dow and the S&P 500 already adjust their respective indexes when a company pays a special, one-time dividend. The price of each index is determined by a "divisior" that divides against the components' share prices (for the Dow), or market cap (for the S&P). After a special dividend is paid, the divisor changes. For example, Microsoft (NAS: MSFT) paid a one-time special $3 per-share dividend in 2004, which caused the Dow's divisor to fall, effectively adjusting the index for the dividend payment. (You can see a list of divisor changes here.)

But those changes only apply to one-time dividends. Normal quarterly dividends aren't adjusted for. Why not? I contacted both Dow Jones and Standard & Poor's, and neither could provide a good explanation. S&P stated that special dividends cause a stock's price to fall after being paid out, which needs to be adjusted for. Yet the same is true for normal dividends. The analyst I spoke with argued that normal dividends are expected by the market and, thus, are already priced into shares, while special dividends are "surprises," affecting the share price. But that's a big, th eoretical assumption. Not all special dividends are surprises, and not all quarterly dividends are expected, particularly in size. If indexes adjust for special dividends, there's no excuse to not adjust for normal ones, too.

Ironically, Standard & Poor's calculates a "total return" index that adjusts for dividend payments. But few pay attention to it, particularly in the media. In the last decade, the S&P 500 Total Return Index has been mentioned in news articles fewer than 100 times, according to Google.

Will we ever get to a point when the media uses dividend-adjusted indexes when reporting the nightly news? I don't think so. The unadjusted numbers are too familiar to be changed. But that doesn't have to stop you. Whenever you're looking at how the market has performed, or how much your portfolio has returned, never, ever, forget to include dividends. Give your returns the credit they deserve.

The article A Modest Plea for a Better Index originally appeared on Fool.com.

Fool contributorMorgan Houselowns shares of Microsoft and B of A preferred. Follow him on Twitter @TMFHousel.The Motley Fool owns shares of Bank of America, Microsoft, and International Business Machines. Motley Fool newsletter services have recommended buying shares of Microsoft. Motley Fool newsletter services have recommended creating a synthetic covered call position in Microsoft. Motley Fool newsletter services have recommended creating a synthetic long position in International Business Machines. The Motley Fool has adisclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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