When they first take an interest in investing in stocks, people tend to want to pull up stock market charts to see how a business has performed over time. For long-term shareholders who practice a buy-and-hold approach, charts are practically useless in all but a handful of cases, because the figures you are seeing in the charts almost certainly understate the total return an investor could have enjoyed had they held ownership throughout the period in question.
Depending on the length of time shown and the capital allocation decisions made by management, the difference between the actual total return and the one depicted can be extraordinary. There are five main reasons why this discrepancy exists and why you should never look at stock charts the same way again.
Eastman Kodak's Example
Before getting to those, let's first start with the extreme example of Eastman Kodak, the photographic film and camera company whose shareholders lost the money they had invested in the stock when the company emerged from bankruptcy in September 2013.
Imagine you had bought $100,000 of shares of Kodak, as the company is often referred to, roughly 25 years earlier, back when it was one of the most prestigious blue chip stocks in the world. That $100,000 would have turned into more than $425,000 over the years despite the stock getting wiped out in the end.
Failure to Reflect Dividends and Other Distributions
Many successful businesses pay out part of their profits in the form of cash dividends. Great businesses are able to increase earnings faster than the rate of inflation, leading to rapid dividend growth.
The dividend yield—a company's annual per-share dividend divided by its stock price and expressed as a percentage—gives investors an idea of how significant a company's dividend payments are in comparison with the amount of money required to buy a share.
Keep in mind that rapidly growing businesses generally trade at higher price-to-earnings ratios than slower-growing ones, which can cause them to have lower dividend yields.
In the case of Kodak, over the quarter-century holding period, dividend payments exceeded the amount of the initial investment: $173,958 versus $100,000.
Failure to Reflect Spin-Offs
One of the greatest perks of being a stock investor is receiving shares of a tax-free spin-off. A company will typically give its existing shareholders stock in a division of the company because the division no longer fits with the core mission of the enterprise and so would be best served on its own. A company may also do it to remove regulatory scrutiny that is focused on that division.
In rare instances, the new publicly traded company goes on to be more successful than the company that spun it off. At the very least, a spin-off gives you shares in a new company, typically without your incurring taxable capital gains.
Going back to Kodak, the stockholder with the initial $100,000 investment would have received $203,018 in Eastman Chemical shares when Kodak spun off its chemical business in January 1994. Those spun-off shares also produced $47,224 in dividends of their own. None of that money shows up in most charts beyond perhaps a pro-rata deduction of the historical cost at the time of separation. This means all subsequent performance is treated as if it had never happened.
Another prime example is Yum! Brands, the parent company of Taco Bell, KFC, and Pizza Hut, which was spun off by PepsiCo in October 1997. While a stock market chart might make PepsiCo appear as if it has lagged Coca-Cola over the past few decades, factor in the Yum! performance post-spin-off, and the two soft drink giants are almost neck and neck.
Failure to Reflect Taxes, Inflation, or Deflation
Taxes matter. The exact same investment, held for the exact same length of time, will result in wildly different net worth changes for your family depending on the asset placement you utilized. Ideally, you'd opt for the twin combination of a 401(k) and a Roth IRA or, at the very least, arrange your affairs to take advantage of the stepped-up basis loophole so your heirs could avoid paying taxes on your deferred tax liabilities. Likewise, stock market charts won't indicate the tax offset you'd receive by selling one position at a loss to shield the gains from another holding.
Inflation and deflation are also sorely missing from most visual representations of securities performance. Purchasing power matters. There are times, such as during the 1929-33 crash, when a decrease in dollars from stock losses is actually a smaller decrease in purchasing power because the cost of everything else also collapsed, resulting in an offset to your wealth destruction. In other words, if the value of your portfolio falls by 50% but the price of everything else falls by 70%, your economic situation is different than it might seem at first glance.
There have been times when a slight drop in the dollar value of an asset actually led to making money in real terms. Conversely, there have been periods during which stock prices rose but the dollar depreciated much more quickly, leading to no real meaningful change for the shareholder.
Fortunately, academic research over the past few generations has demonstrated that, over long stretches of time, stocks, in the aggregate, have always been successfully able to compensate for inflation despite occasional periods to the contrary in the short term.
Failure to Reflect Costs
When it comes to growing your family's fortune, costs matter. Every penny you lay out in expenses is a penny you don't have that could be generating compound interest. If, before the rise of online trading, you paid a broker $100 to execute a stock trade, your costs were very high compared with the value of your assets. The individual differences in the efficiency of stock purchases can't appear in stock charts, but they're still of great importance.
The Hidden History of Some Companies
Let's say you admire the late Dave Thomas and were curious how a stockholder in the original IPO of the Wendy's restaurant chain would be faring today. You can't easily do that because Wendy's was acquired by Triarc Companies, the publicly traded parent company of Arby's, with the stock symbol TRY, in 2008.
After a series of name changes and divestments, Wendy's Co. is now once again its own publicly traded company, with a different stock symbol (WEN). The trading history of the enterprise Dave Thomas built and expanded hasn't actually been the simple picture you see in a continuous, decades-long chart.