Wednesday, February 13, 2008

Value weighted returns or dollar weighted returns

We normally compute stock returns using a value weighted index, made up of the stocks in the market weighted by their market caps. But fund managers use a different approach (sort of) - they weight their returns by the amount of money that they had invested in the market. So the months when they were more heavily in the market are more important than the returns from the months when they were not as heavily in the market.

So what - well a study has applied this method to the overall stock market and looked at time dollar weighting the returns based on how much money was invested at a particular time. The results are not encouraging. Market participants are bad at timing the market...For example, the performance of the S&P 500 would fall by 1.4% from 10% a year to 8.6% on a market timing basis.

Article here (source Hal Varian's website and the NY Times)