Scandinavian Working Papers in Economics
Working Papers in Economics,
University of Gothenburg, Department of Economics
No 767: Compound Returns
Adam Farago (adam.farago@economics.gu.se) and Erik Hjalmarsson (erik.hjalmarsson@economics.gu.se)
Additional contact information
Adam Farago: Department of Economics, School of Business, Economics and Law, Göteborg University, Postal: P.O. Box 640, SE 40530 GÖTEBORG, Sweden
Erik Hjalmarsson: Department of Economics, School of Business, Economics and Law, Göteborg University, Postal: P.O. Box 640, SE 40530 GÖTEBORG, Sweden
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.
Keywords: Compound returns; Diversification; Long-run returns; Skewness
82 pages, June 2019
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