81 Pages Posted: 15 Jun 2019 Last revised: 1 Oct 2019
Date Written: June 3, 2019
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: Suggested Citation