Compound Returns

Adam Farago () and Erik Hjalmarsson
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Adam Farago: Department of Economics, School of Business, Economics and Law, Göteborg University, Postal: P.O. Box 640, SE 40530 GÖTEBORG, Sweden, https://economics.gu.se/

No 767, Working Papers in Economics from University of Gothenburg, Department of Economics

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 (search for similar items in EconPapers)
JEL-codes: C58 G10 (search for similar items in EconPapers)
Pages: 82 pages
Date: 2019-06
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