Investors Don’t Generate Security Returns

An important question is what type of returns investors truly generate. We know what the returns for a security return will be. We just calculate the geometric returns from the changes in price. Unfortunately, the returns that are generated by investors have to be dollar weighted by when funds were invested in the market. This represents not the compounded geometric returns but the internal rate of return calculated from the flows of money into the market. The issue seems obvious but is over overlooked in discussions of returns.

Ilia Dichev of the University of Michigan, focused on this issue for the market as a whole for both the United States and international stock markets. (See “What are Stock Investors Actual Returns? Evidence from Dollar-Weighted Returns” American Economic Review March 2007.) He used a large number of countries for as long a time period as possible to calculate investor returns. Perhaps not surprising the returns by investors when time weighted are lower than the measured security returns.

Investors have a tendency to add more money at market highs and take money out at the lows. The phenomena occur across all of the major international stock markets and for very long horizons. There is a clear positive correlation between money invested or added to the market and performance. Some of additions are from new equity issuance. Some additions and redemptions are due to the economic cycle. Money will be added or withdrawn relative to variable consumption needs or wealth changes. Flows are driven by expectations which may be rational relative to the other investment choices or motivated by momentum. The importance of this work goes beyond the simple conclusions that we may be poor investors. It also tells use that the actual excess returns that we generate are less than what has been calculated by many researchers. When we look at actual behavior in the markets, there is a smaller excess return premium. The equity premium puzzle may not exist.

This type of analysis, using internal rate of return calculations, is consistent with what has been found with mutual fund investing. Investors do not time their flows effectively. The advice from this type of work is clear. Security returns are not the same as investor returns and everyone should focus on the timing of their cash flows into and out of the market.