When you first begin investing in stocks, you may want to pull up stock market charts to see how a business has performed over time. For those who use a buy-and-hold approach, charts are most often useless in all but a handful of cases. That's because the figures you are seeing in the charts almost always understate the total return you could have enjoyed if you'd held ownership throughout the period.
Depending on several factors, the difference between the actual total return and the one depicted can be quite large. Learn about the main reasons why this discrepancy exists.
Example: Eastman Kodak
Let's first start with the extreme example of Eastman Kodak. This was a photographic film and camera company. Its shareholders lost the money they'd invested in the stock when the company emerged from bankruptcy in 2013.
Now, let's say you had bought $100,000 of shares of Kodak roughly 25 years earlier. That was back when it was one of the most prestigious blue-chip stocks in the world. Your $100,000 would have turned into more than $425,000 over the years. That's despite the stock getting wiped out in the end.
How Does It Fail to Reflect Dividends and Other Distributions?
The dividend yield gives investors an idea of how significant a company's dividend payments are compared to the amount of money needed to buy a share.
Remember: Rapidly growing businesses often trade at higher price-to-earnings ratios than slower-growing ones. This can cause them to have lower dividend yields.
Now, let's look at Kodak's case. Over the 25-year holding period, dividend payments exceeded the amount of the initial investment: $173,958 vs. $100,000.
How Does It Fail 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 often give its existing shareholders stock in a division of the company. That's because the division no longer fits with the core mission of the enterprise; in that case, it 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. And most often, you won't incur taxable capital gains.
Let's go back to the Kodak example. With your initial $100,000 investment, you would have received $203,018 in Eastman Chemical shares when Kodak spun off its chemical business in 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. It was spun off by PepsiCo in 1997. A stock market chart might make PepsiCo appear as if it has lagged behind Coca-Cola over the past few decades. But if you factor in the Yum! performance post-spin-off, the two soft drink giants are almost neck and neck.
How Does It Fail To Reflect Taxes, Inflation, or Deflation?
Taxes matter. The exact same investment, held for the exact same length of time, can result in very different net worth changes It depends on the asset placement you use. Ideally, you'd opt for the twin combination of a 401(k) and a Roth IRA. Or, at the very least, you'd arrange your affairs to take advantage of the stepped-up basis loophole. That way, 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 crash, when a decrease in dollars from stock losses is actually a smaller decrease in purchasing power; that's because the cost of everything else also collapsed. This could result in an offset to your wealth destruction.
In other words, what if the value of your portfolio falls by 50%, but the price of everything else falls by 70%? Your economic situation would be 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. In these cases, there is no real meaningful change for the shareholder.
Over long stretches of time, stocks, in the aggregate, have always been successfully able to compensate for inflation. This is despite occasional periods to the contrary in the short term. This has been shown by research over the past few generations.
How Does It Fail to Reflect Costs?
When it comes to growing your family's fortune, costs matter. Every penny you pay in expenses is a penny you don't have that could be making compound interest. Let's say that, before the rise of online trading, you paid a broker $100 to execute a stock trade. In that case, your costs were very high compared with the value of your assets.
The 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 of Wendy's. You're curious how a stockholder in the original IPO of the restaurant chain would be faring today. You can't easily do that; that's because Wendy's was acquired by Triarc Companies in 2008. Triarc is the publicly traded parent company of Arby's, with the stock symbol TRY,
After a series of name changes and divestments, Wendy's Co. is now once again its own publicly-traded company. And it has a different stock symbol (WEN). The trading history of the enterprise Mr. Thomas built and expanded hasn't actually been the simple picture you see in a continuous, decades-long chart.