Wealth Through Brain-Dead Investing

A few weeks ago I had the pleasure of listening to Wharton business school professor Jeremy Siegel give a talk on the stock market. You may know him from his terrific book, Stocks for the Long Run, which demonstrated the long-term superiority of stocks over other investments. It's very readable and educational. Siegel has just come out with a new work: The Future for Investors: Why the Tried and the True Triumph Over the Bold and the New. Much of his talk offered some rather amazing insights from this latter book.

The original S&P 500
Think for a minute of our old friend, the Standard & Poor's 500 index. The S&P 500 has been around for nearly 50 years. A few years ago, Siegel asked himself what would have happened if someone had invested in the S&P 500 when it was launched and then never sold. For one thing, this wouldn't have been an easy feat since there was no convenient index fund available at the time -- an investor would have had to buy individual portions of 500 companies, making adjustments every time a firm was added to or dropped from the list. Siegel discovered that this was in fact such a difficult question to investigate (involving so many mergers, spinoffs, and so on) that no one had tackled it yet. Armed with research assistants, he took it on.

What we might have expected
There has been a lot of turnover in the S&P 500 since its inception. Of the original 500 companies, only 125 remain in their original form. There were 92 mergers, 111 spinoffs, and 11 firms that became public after having been privatized. Siegel ended up with a "total descendents portfolio" of 339 companies.

Over time, as America's economy has changed, so has the S&P 500. Manufacturing has decreased in importance over the past century, while health care, information technology, and financial firms, among others, grabbed bigger pieces of the economic pie. Those three sectors accounted for just 6% of the S&P 500 in 1957; today, they make up around 50% of it. On average, about 20 firms were added to the S&P 500 each year and since 1957, about 1,000 companies joined the list while others exited.

Many people might rather reasonably expect that the new additions would do the best over time. After all, they were in growing industries. But in nine of 10 sectors, the new firms did worse than the older ones. Between 1957 and 2003, the S&P 500 grew at an average annual clip of 10.85% (with a risk measure of 17.02%), compared with 11.4% growth for the total descendents (with a risk measure of 16.08%). So with less risk, the descendents fared considerably better. If you'd plunked $5,000 into each group in 1957, it would have grown to about $571,000 in the S&P 500 and $717,000 in the total descendents. The latter group did much better!

What happened?
According to Siegel: "Although the earnings, sales and even market value of the new firms grew faster than those of the older firms, the price investors paid for these stocks was simply too high to generate good returns. These higher prices meant lower dividend yields and therefore fewer shares accumulated through reinvesting dividends." Think, for example, of when Yahoo! (NASDAQ:YHOO) was added to the S&P 500 in late 1999. The move was announced several days before it was actually added, giving investors time to bid the shares up considerably (in this case, 64%!). Even before being bid up, the shares were trading at lofty levels.

Lessons for us
So what lessons should we draw from all this? Here are a few:

• Dividends really matter. Siegel divided the S&P 500 into five groups, or quintiles, according to dividend yield. He found that the quintile with the highest yields outperformed the quintile with the lowest yields -- with average annual returns of 14.27% vs. 9.5%. He listed 20 top-performing survivor stocks in the S&P 500 from 1957 to 2003, including Altria Group (NYSE:MO), with an average annual return of 19.75% (enough to turn $1,000 into $4.6 million); Abbott Labs (NYSE:ABT), at 16.51%; Merck (NYSE:MRK), at 15.9%; Heinz (NYSE:HNZ), at 14.78%, Fortune Brands (NYSE:FO), at 14.55%); and Wyeth (NYSE:WYE), at 13.99%. Between 1957 and 2003, $5,000 would have turned into $325,000 in the lowest-yield quintile and $2.3 million in the highest-yield quintile. That's quite a difference!
  
  
• Hanging onto an investment for the long haul and resisting rapid turnover is often a profitable endeavor. You should never hold on blindly, of course, but inactivity can be smart. Even Warren Buffett told shareholders one year that, "Overall, you would have been better off last year if I had regularly snuck off to the movies during market hours." Siegel himself used the term "brain-dead investing" to describe this way of getting wealthy.
  
  
• There are some problems with index funds -- such as when they add overpriced companies to their holdings.

So what now?
If you're wondering how to act on this information, you have a bunch of options.

• You might plunk some money into an index fund and forget about it for 46 years.
  
  
• You might seek out exceptional dividend-paying companies and invest in them for the long haul. Let us help you, if you'd like. I invite you to give our Income Investor newsletter service a whirl -- for free. In more than two years of monthly recommendations, lead analyst Mathew Emmert has racked up an average gain of about 17%, topping the S&P 500's return of roughly 13% handily. Fully 29 of his recommendations, last time I checked, offered yields above 4%, many of them much higher than that (about seven sported yields of more than 8%). A free trial will allow you to review all past issues and all recommendations.
  
  
• You might seek to avoid being punished by index fund drawbacks by investing in carefully selected managed mutual funds with strong, market-beating track records.

Here's to a more profitable portfolio!

Selena Maranjian's favorite discussion boards include Book Club , The Eclectic Library , Television Banter , and Card & Board Games . She owns shares of no company mentioned in this article. For more about Selena, view her bio and her profile . You might also be interested in these books she has written or co-written: The Motley Fool Money Guide and The Motley Fool Investment Guide for Teens . Merck is a recommendation of the Income Investor newsletter service. The Motley Fool is Fools writing for Fools.