October 4, 1997 in Nation/World

Is The Dow Dog Investment Theory Overblown?

Knight-Ridder Newspapers

Are the “Dogs of the Dow” overblown?

That’s always been hard to determine, since statistics that make the Dogs investment strategy look good don’t reflect real-world factors that reduce returns, such as investment timing, commission costs and taxes. But a new study purports to take those factors into account - and concludes the Dogs do not “beat the Dow,” as believers have claimed.

The strategy calls for investing equal amounts in the 10 stocks with the highest dividend yields in the Dow Jones industrial average. After 12 months the portfolio is adjusted to match the new list.

In theory, the Dogs stocks have high dividend yields (dividend divided by price) because the price is abnormally low. The investor thus earns high dividends and profits when the stocks rebound.

A portfolio invested in the Dogs from 1972 through 1996, with all dividends reinvested, would have had an average annual return (including compounding) of 18.34 percent, compared with 12.76 percent for the 30-stock Dow. But a real investor probably wouldn’t own the portfolio for that long and would have to pay commissions and taxes each year, leaving less to reinvest and lowering the long-term average.

Grant McQueen and Steven R. Thorley, assistant finance professors at Brigham Young University, and Kay Shields, a financial planner in Glendale, Ariz., reported in the July/August edition of Financial Analysts Journal that real-world factors erode most of the Dogs’ advantages over the Dow.

The researchers found that from January 1946 through December 1995 the Dogs strategy had an average annual return (not including compounding) of 16.77 percent, compared with 13.71 percent for the Dow. But the Dogs were riskier, with a “standard deviation” of 19.1 percent, compared with the Dow’s 16.64 percent. The bigger the number, the wilder the portfolio’s price swings. If you had to liquidate in a downswing, you’d do worse in the Dogs than the Dow.

The researchers found the Dogs’ risk could be lowered to the Dow’s level by investing 13 percent of the portfolio in Treasury bills. This “risk-adjusted” Dogs portfolio, which the researchers say offers a better apples-to-apples comparison, returned only 15.23 percent against the Dow’s 13.71 percent.

The researchers said about three of the 10 Dogs stocks change every year, forcing trades that rack up commissions. Changes in the Dow are very rare. Commissions averaging 1 percent per transaction would cut the Dogs’ return to 14.64 percent, while the Dow would drop only a tad, to 13.69 percent.

That 0.95-point difference would probably be chewed up by higher taxes incurred by the Dogs, the researchers said. The frequent portfolio changes would trigger capital-gains tax, and the higher dividend yield would bring more income tax.

When all these factors are taken into account, the researchers said, the Dogs strategy “probably does not beat the Dow 30.”

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