Buggy Whips, GM, Cisco & the Dow

How many times have you heard the claim that the market always rises in the long term? It’s a dangerous and misleading market myth underscored by the deletion of General Motors from the S&P 500 and the Dow this week. The reality is that the top companies rarely remain top companies for extended periods when long term investment horizons are considered.

At the turn of the 20th century the top blue chip industries included buggy whip manufacturers. Their future looked assured, particularly if you ignored the new-fangled, noisy and slow automobiles that were successful only in frightening the horses.

Less than two decades into the 20th century the buggy whip industries had been superceded.

The first decade of the 21st century is witnessing a similar transfer of industrial and commercial power. GM is being replaced with Cisco — the Chevy's been routed off the road, replaced by the builder of e-networks, the next generation of highways.

Analysts and commentators trot out a chart display going back to 1850 to show the market in a consistently rising trend. The large falls in 1930, 1987, 2001 and more recently 2008, seem to disappear in this ever-rising trend.

The idea of constantly rising market is a compelling and attractive myth. This myth fails to distinguish between the behavior of the market index used to measure market performance, and the market itself.

Survivor bias lies at the core of every index and the ever-rising trend. We start with a sample index with four stocks. They are red, yellow, green and light blue. The original index is constructed as the result of careful research. The objective is to locate the largest stocks by capitalization and the most important of the blue chip stocks.

This is an index by invitation only. Constructing and maintaining the index is now big business because many fund managers are required to use the index as a benchmark. Constructing and maintaining any index is complex work, but they all have a common feature at heart.

Every index is re-calibrated, or adjusted, at regular intervals. Some are re-calibrated every three months. The Index guardian assesses the stocks that are included in the original index. They delete index stocks that are under-performing the index, or market benchmark.

In this example, the green stock is dropped in Index Review 1. This leaves the index with only three stocks, so a new stock must be added to the index. In this example, the pink stock is added. The constituents of Index Review 1 now make a slightly different index from the Original Index.

The 'surviving' stocks are red, yellow and light blue. These retained stocks are survivors and they add an inevitable upward bias to the index, as does the extra pink 'winner' stock.

In real terms we could say the green stock in the original index represented GM. When GM stops being a winner, it's dropped from the index and replaced by Cisco, a better performing stock.

The extended diagram of the sample four stock index shows how survivor bias compounds over time. At every index review point the under performing stocks are dropped and stronger performing stocks are added.

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The Current Index on the right side does not include any of the stocks in the Original index on the left side. Despite this complete change in the membership of the index, the index is still treated as if it is a single unchanged entity that shows a continuous rise.

Whilst it is true the concept of the index is unchanging, it is important to remember that the membership of the index is always changing to select retrospective winners. This is survivor bias.

It explains why Cisco is now a member of the unchanging concept called the Dow Jones Industrial Average, which has a continuous history that began long before Cisco started business.

The index always rises because it only includes winners, but the reality is that the market includes BOTH winners and losers.

While GM has gone the same way as the buggy whip, the index still moves upwards in the long term. Smart investors should use Exchange Traded Funds to avoid being left holding the buggy whip - and GM.

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