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My Two Cents

The DJIA Crossed 554,428. Say What?

Chris Farrell Apr 22, 2008

Warren Buffett’s annual report is always a wonderful read, full of insight and investment wisdom. A number of people have talked to me about this passage:

I should mention that people who expect to earn 10% annually from equities during this century – envisioning that 2% of that will come from dividends and 8% from price appreciation – are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about double digit returns from equities, explain this math to him – not that it will faze him. Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many
as six impossible things before breakfast.” Beware the glib helper who fills your head with fantasies while he fills his pockets with fees.

I couldn’t agree more.

Buffett’s musings on investment returns reminded me of an academic paper I read several years ago with the improbable title, “The DJIA Crossed 554,428 (in 1997).” You can imagine my skepticism. But this wasn’t one of those “Dow 36,000” or “Dow 40,000” forecasts that was popular at the end of the ’90s. It was serious research into how equity values are measured. The authors, Meir Statman, a finance economist at Santa Clara University, and Roger Clarke, an international money manager, made an observation about returns that has stuck with me.

The Dow Jones Industrial Average, the most famous measure of the stock market, started out with a value of $40.96 in 1896. That year, an 18 year-old with that sum in his wallet–about $700 in 1997–could have had a terrific evening about town with some friends. Or, he could have invested the $40.96 in the stocks that made up the Dow Jones Industrial average and reinvested all the dividend income. By the 1997–at the creaking old age of 122–he would have accumulated a nest egg of $540,294. Of course, all the money would go toward medical bills. On the other hand, he could have spent the dividend income and still have $7,908 left over. “These are just three of the infinite number of ways you could be rich if you had $40.94 in 1896,” say Statman and Clarke.

Investment returns is only one part of the equation. We don’t eat total returns. It’s what you do with the money that matters.

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