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Buy and hold, please
For Nasdaq, the difference between buy-and-hold and dollar-weighted returns is even larger. An investor who bought the Nasdaq index in 1973 and sold in 2002 would have earned an average yearly return of 9.6 percent. But the typical investor in Nasdaq earned only 4.3 percent over this period. This is true not just in the United States — the same thing occurred in 18 of 19 international markets that Mr. Dichev examined.
That's Hal Varian, who argues that actively trading investors are excessively swayed by what is in the news, thus earning less than random returns. If you can't restrain your trading, at least chuck your newspapers and magazines.
Posted by Tyler Cowen on May 3, 2007 at 07:23 AM in Economics | Permalink
Comments
This was the thesis in Fooled by Randomness, which deserves a mention in such a conenction..
Posted by: John Goes at May 3, 2007 7:30:57 AM
Or, if you're really disciplined, consider the trades you think you want to do, then do the opposite.
Posted by: M. Hodak at May 3, 2007 7:38:10 AM
So if the stocks managed 9.6%, but the "typical" investor only saw 4.3, where did the rest of the $ go? Shouldn't the sum of investors come back to 9.6?
Posted by: Nate at May 3, 2007 8:07:11 AM
Nate,
Now you know how hedge funds earn the kinds of returns they do.
Posted by: nelsonal at May 3, 2007 8:43:36 AM
Speaking of something not being 'news'....
Posted by: Patrick R. Sullivan at May 3, 2007 9:30:12 AM
Nate some of it goes to the other's who get the 9.6%. Some goes to the hedge funds (which are probably part of the 9.6%ers). And a very big chunk of it probably goes to transaction costs.
Posted by: aaron at May 3, 2007 9:30:28 AM
You guys missed Varian's point. The "missing" return is based on investors trading in and out of the Nasdaq. the 9.6% is the time-weighted return, the 4.3% is the dollar-weighted return. Investors buying at the top and selling at the bottom is what leads to the huge mismatch b/w time and dollar weighted returns.
There is a ton of data on mutual fund performance and the huge delta b/w time and dollar weighted returns. David Swensen of Yale has calculated that over the period 1996-2005 investor peformance in mutual funds lagged the time-weighted return by 13% per year (not percentage points, so if the return was 10% in the fund, investors got 8.7%). Another example is that many investors in the tech bubble got killed. A "hot" new tech fund would be up say 100% in 1999 on $100M of assets. Investors would notice the performance and pour assets into the fund, ballooning assets to say $1B by the end of Q1 2000. The fund then loses 75% over the next two years. The funds three year performance is then down 50% on a time weighted basis, but on a dollar weighted basis it will be much closer to 75%, since the vast majority of assets were invested AFTER the fund had doubled in 1999. To add insult to injury, investors also got hit with huge capital gains bill in 2000, sometimes equal to as much as 20% of assets. (these numbers are made up, but there are plenty of real examples, I'm just too lazy to find them. The Jacobs Internet Fund and Munder NetNet fund are two that come to mind).
Posted by: joe at May 3, 2007 9:45:44 AM
So does this mean the market is actually grossly inefficient?
Posted by: Mr. Noah at May 3, 2007 10:27:40 AM
I think Varian has misread the paper. The paper really says nothing about styles of trading like buy and hold investors or active traders. Indeed, mathematically it is impossible for the aggregate return to be affected by who buys and sells a particular stock at which time. If person #1 sells a stock to person #2 that might change person #1's return but it cannot change the aggregate return.
However, firms CAN affect the aggregate return by issuing or buying back stock. This is the point of the article. What the author documents is that companies issue stock when the market is high (duh, think late 1990s tech IPOs) and buy back stock when they think their companies' stock is undervalued. Apparently they do a better job of timing the market than individual investors. This is the source of the discrepancy between time weighted and dollar weighted returns. It's got nothing to do with being a buy and hold investor versus an active trader.
I don't see an obvious solution for individual investors--all mutual funds or index funds must almost by construction expand and contract with aggregate capital flows into and out of the market. Maybe I should sell when I see lots of IPOs and buy when I see lots of buybacks...
Posted by: adam at May 3, 2007 11:44:29 AM
1. Terry Odean of UC Berkley had very similar research results.
2. Peter Lynch always said the advertised returns of his funds were always considerably better than those realized by the investors of the funds. Investors buy what has been hot recently and then sell when they under perform.
3. Terry Odean has a great research article showing that individual investors who outpeformed the market recently, were more likely to underperform in the future because they had more confidence in their abilities than reality. People who trade well equate their performance with their own ability and when they trade poorly blame the market.
Posted by: Steve Roberts at May 3, 2007 11:55:55 AM
Adam what you say would only make sense if there was a fixed number of investors over the period of time who were each invested in every stock in the market. It is possible that I can sell Home Depot in 1999 at $60 to some other rube willing to pay 50x earnings for a retailer and then go to cash, or buy an undervalued small cap company or invest in timber, etc... The NASDAQ example shows that people's market timing - trading in and out of the NASDAQ - is very poor and they suffer as a result. If the only choice was to invest in the NASDAQ, then sure the aggregate returns would have to equal the index return, less transaction costs. But reality is quite different.
Posted by: joe at May 3, 2007 2:06:16 PM
The paper suggests that on a dollar weighted basis investors receive below average returns, compared to returns reported as earned by the market. In essence, investors add more money near the end of a bull market, so their average dollar invested only captures the late price rise.
Posted by: rmark at May 3, 2007 2:15:47 PM
Adam, after closer examination, your comment appears correct. Varian did misread the paper. It has nothing to do with trader behavior or getting in and out at the wrong time. My previous comment was meant to bring up the point that for every buy transaction there is a comparable sell transaction, so that the "typical" investor is held neutral to any amount of trading activity. The only exceptions to this (pointed out by Adam) are secondary stock issues, buybacks, and dividends where the counterparty is the company itself.
A couple of thoughts: 1. can we look at corporate stock buybacks as a massive insider trade (being done on average in times just before better-than-average returns) and 2. does this show that companies who issue dividends tend to perform better in the future (or, to be causality-neutral, companies in a position to do better in the future are more likely to issue dividends now)
Posted by: Nate at May 3, 2007 2:35:11 PM
1. Every buy does not automatically produce a market sale. Ever heard of an IPO or secondary offering?
2. Companies that pay dividends have historically produces significantly higher returns than companies who do not. Companies who raise their dividends over time have a history of out performing companies who do not raise their dividends.
Posted by: Steve Roberts at May 3, 2007 3:45:50 PM
Steve, regarding your points:
1. Please note that I acknowledged your exceptions in my post. My comment is meant to refute the arguments of traders all being of the variety where they chase rising stocks only to get crushed later. Other than the exceptions we agree on, there is a trader on the other side who benefitted to an ofsetting amount.
2. If you are right, then I bet the results from the whole paper can be explained by this. All of those dividends probably affect the calculations much more than secondary offerings, so if a small div payer outperforms a non-payer by 1% and a large div payer outperforms the small by another 1%, then...
I'm sure there are a bunch of discussions and papers on why div payers could do better in the long run (signaling, advantage in capital access, etc...)-- so does that mean this particular paper is just regurgitating old news using different calculations?
Posted by: Nate at May 3, 2007 4:50:34 PM
So does this mean the market is actually grossly inefficient?
I'd say its more a matter of the market being perfectly efficient. Price adjustments happen so rapidly that there is essentially no time for arbitrage in the long run. By the time any one investor can react to a given piece of news (excluding outsider trading), the herd has already begun its "stampede."
Posted by: jn at May 3, 2007 6:53:59 PM
Outsider trading? I meant insider. Oops.
Posted by: jn at May 3, 2007 6:55:16 PM
Nate:
Dividend payers don't really have a factor in the research. The point is that buy and hold investors out perform frequent traders for rather obvious reasons.
1) buy and hold are always in the market. All research pretty much shows that time in the market is more important than timing and traders frequently have significant amounts of money on the sidelines. Ever read about them having dry powder in case the market drops? They are trying to trade the market.
2. traders routinely experience significantly higher cost which is difficult to impossible to overcome without taking significantly higher risk than the market as a whole.
3. My experience is that anyone who bought a moderately risky portfolio of dividend paying companies who raise their dividends over time will out perform the market as a whole over time. To be a dividend payer equates to a certain degree of financial safety and success. My preference are insurance companies, regional banks and consumer goods with powerful brand names. Oh wait, those are Warren Buffet's ideas! :o)
Posted by: Steve Roberts at May 4, 2007 12:19:02 PM
