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Compound Returns

Author

Listed:
  • Farago, Adam

    (Department of Economics, School of Business, Economics and Law, Göteborg University)

  • Hjalmarsson, Erik

    (Department of Economics, School of Business, Economics and Law, Göteborg University)

Abstract

We provide a theoretical basis for understanding the properties of compound re-turns. At long horizons, multiplicative compounding induces extreme positive skewness into individual stock returns, an effect primarily driven by single-period volatility. As a consequence, most individual stocks perform very poorly. However, holding just a few stocks (instead of a single one) greatly improves the long-run prospects of an investment strategy, indicating that missing out on the “lucky few” winner stocks is not a great concern. We show analytically how this somewhat counterintuitive result arises from an interaction between compounding, diversification, and rebalancing that has seemingly not been previously noted.

Suggested Citation

  • Farago, Adam & Hjalmarsson, Erik, 2019. "Compound Returns," Working Papers in Economics 767, University of Gothenburg, Department of Economics.
    • Handle: RePEc:hhs:gunwpe:0767
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    File URL: http://hdl.handle.net/2077/60415
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    More about this item

    Keywords

    Compound returns; Diversification; Long-run returns; Skewness;
    All these keywords.

    JEL classification:

    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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