What are Stock Investors' Actual Historical Returns? Evidence from Dollar-Weighted Returns

Abstract

The existing literature typically does not differentiate between security returns and the returns of investors in these securities; usually implicitly, these two concepts are assumed to be the same. However, the returns of stock investors depend not only on the returns of the securities they hold but also on the timing of their capital flows into and out of these securities. This paper suggests a new and more accurate measure of stock investors' historical returns, which involves dollar-weighting of the returns and properly reflects the effect of investors' timing. Theoretically, the essence of dollar-weighted returns is that they value-weight both the cross-section and the time-series of returns. In practical terms, dollar-weighted returns are computed as internal rate of returns (IRRs) from investment projects in which initial market values and contributions from investors (e.g., stock issues) enter with negative signs, and distributions to investors (e.g., dividends, stock repurchases) and final market values enter with positive signs. The empirical results indicate that aggregate dollar-weighted returns are systematically lower than buy-and hold returns. The annual difference is 1.3 percent for the NYSE/AMEX market over 1926-2002, 5.3 percent for Nasdaq over 1973-2002, and averages 1.5 percent for 19 major stock markets around the world over 1973-2004. Thus, this study provides comprehensive evidence that stock investors' actual returns are considerably lower than those from passive holdings and from those documented in the existing literature on historical stock returns. These results have implications for the debate on the equity premium, for the literature on long-run returns following capital flows, for building successful investment strategies, and others.