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Hindsight Effects in Dollar-Weighted Returns

2014; Cambridge University Press; Volume: 49; Issue: 1 Linguagem: Inglês

10.1017/s0022109014000155

1756-6916

Simon Hayley,

Financial Reporting and Valuation Research

Abstract A growing number of studies use dollar-weighted (DW) returns as evidence that bad timing substantially reduces investor returns, and that consequently the equity risk premium must be considerably lower than previously thought. This paper demonstrates that this method is subject to a hindsight effect (as prior returns influence levels of new investment) and derives a technique that corrects it. The results show that for mainstream U.S. equities, DW returns are low because of this hindsight effect (bad investor timing had very little impact). Thus, low DW returns do not imply that the risk premium is correspondingly low.