Compound Returns

81 Pages Posted: 15 Jun 2019 Last revised: 1 Oct 2019

See all articles by Adam Farago

Adam Farago

University of Gothenburg - Centre for Finance

Erik Hjalmarsson

University of Gothenburg - Centre for Finance

Date Written: June 3, 2019

Abstract

We provide a theoretical basis for understanding the properties of compound returns. 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

JEL Classification: C58, G1

Suggested Citation

Farago, Adam and Hjalmarsson, Erik, Compound Returns (June 3, 2019). Available at SSRN: https://ssrn.com/abstract=3398501 or http://dx.doi.org/10.2139/ssrn.3398501

Adam Farago (Contact Author)

University of Gothenburg - Centre for Finance ( email )

Box 640
Gothenburg, 405 30
Sweden

Erik Hjalmarsson

University of Gothenburg - Centre for Finance ( email )

Box 640
Gothenburg, 403 50
Sweden

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