Dow 39,000

The stocks that make up the Dow Jones Industrial Average (^DJI 0.55%) are intended to serve as a reflection of the overall stock market and the U.S. economy. But in the first four decades of the Dow's existence, the committee that chose the stocks acted like a group of short-term traders, making 74 changes to the index. If they had been less active and held the Dow's components for the long term, the Dow would be perched far higher today. Read on to find out why the Dow should be at 39,000 and how you can profit from Dow Jones' mistake.

The Dow Jones Industrial Average is currently made up of 30 stocks. Membership in the Dow is not rules-based but has been determined over the years by a committee of Dow Jones and Wall Street Journal employees. Currently the committee is made up of The WSJ's managing editor, the head of Dow Jones Indexes research, and the head of CME Group research. (CME Group bought a 90% stake in the Dow Jones' indexes business from News Corp. in 2010.)

At its inception in 1896, the Dow was made up of just 12 stocks. It was expanded to 20 in 1916 and to its current 30 in 1928. Not including expansions, the Dow committee has removed and replaced 111 stocks over the index's 117 years in existence. That activity, though, was mainly concentrated in the first 43 years of the Dow's history.

Source: Dow Jones.

During that 43-year stretch, the committee constantly bought and sold. For example, General Electric (GE 1.15%) was one of the original 12 Dow stocks, removed in 1898, added back in 1899, removed again in 1901, and finally added back for good in 1907. Yet while the American economy has changed much over the decades, the dominant Dow businesses haven't fluctuated anywhere near as much. As a result, the Dow would have been far higher today had the committee stuck with its picks and held them for the long run.

The Dow's mistake
Among its mistakes, one of the committee's biggest was removing IBM (IBM -1.45%) just seven years after adding it in 1932, to make way for AT&T (T 1.36%). According to Bryan Taylor, chief economist of Global Financial Data, AT&T was kicked out of the Dow Jones Utilities average after the Dow committee decided to restrict the index to only power companies. The next year, the committee decided that as one of America's largest companies, AT&T should be in the Dow Jones Industrial Average, and so IBM got the boot. That act of short-term thinking would cost the Dow for years to come. IBM didn't return to the Dow until 1979, and in the 40 years it was off the index, it had increased more than 220-fold, while AT&T didn't quite triple.

What kind of difference would that have made to the index? Well, on June 29, 1979, when IBM returned, the Dow closed at 841.98. Granted, this is a simplification of the math, but if you subtract AT&T's contribution to the Dow during the 40 years IBM was absent and add in IBM's performance during that period, the Dow would have closed June 29, 1979, at 23,069 -- 22,227 points higher than its actual close that day. It would be sitting at nearly 39,000 today, more than double its current 16,491.

The ability of one stock to have such a massive effect on the Dow is one of the main reasons I'm not a fan of it, especially as many people's perceptions of the health of the U.S. economy is based on its performance. But the fact that the index could easily be sitting at 39,000 if it had just held on to one stock is a great example of the power of long-term investing and Warren Buffett's assertion that his favorite holding period is "forever."

Bottom line
We Fools don't invest in the broad market. We invest in great companies at good prices, continue to educate ourselves, and hold on to our great companies over the long term. The market will fluctuate, sometimes massively, but great companies will win out over the long run. That's a lesson the Dow could take to heart.