Simon Hayley

Diversification Returns, Rebalancing Returns and Volatility Pumping

There is now a substantial literature on the effects of rebalancing on portfolio performance. It is widely argued in the theoretical literature that rebalanced strategies are inherently likely to generate greater terminal wealth than unrebalanced strategies, although empirical studies do not generally support this claim. We show that this claim is based on a misattribution between ‘rebalancing returns’ which are specific to the act of rebalancing, and ‘diversification returns’ which can be earned by both rebalanced and unrebalanced strategies. Confusion appears to have increased because in some situations these two distinct effects have the same magnitude. This issue has important implications for return attribution in diversified portfolios. Misleading claims about the benefits of rebalancing are likely to lead investors into strategies which involve insufficient diversification and excessive transactions costs.

Market and Style Timing: German Equity and Bond Funds

We apply parametric and non‐parametric estimates to test market and style timing ability of individual German equity and bond mutual funds using a sample of over 500 equity and 350 bond funds, over the period 1990–2009. For equity funds, both approaches indicate no successful market timers in the 1990–1999 or 2000–2009 periods, but in 2000–2009 the non‐parametric approach gives fewer unsuccessful market timers than the parametric approach. There is evidence of successful style timing using the parametric approach, and unsuccessful style timing, particularly in the 2000–2009 period. There is evidence of positive and negative bond timing in the 2000–2009 period.

Hindsight Effects in Dollar-Weighted Returns

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.

Dollar Cost Averaging - The Role of Cognitive Error

Dollar Cost Averaging (DCA) has long been shown to be an inefficient investment strategy in mean/variance terms, yet it remains very popular. Recent research has attempted to explain this popularity by assuming more complex investor preferences. However, this paper demonstrates that DCA is a sub-optimal strategy regardless of the form taken by investor preferences over terminal wealth. Instead it offers a simpler explanation: that DCA’s continued popularity is due to a specific and demonstrable cognitive error in the key argument that is normally put forward in favor of the strategy. This explanation brings very different welfare implications.

Measuring Investors' Historical Returns: Hindsight Bias in Dollar-Weighted Returns

A growing number of studies use dollar-weighted returns as evidence that consistently bad timing substantially reduces investor returns, and that consequently the equity risk premium must be considerably lower than previously thought. These studies measure the impact of bad timing as the difference between the geometric mean return (corresponding to a buy-and-hold strategy) and the dollar-weighted return. However, the present paper demonstrates that this differential combines two distinct effects: The correlation of investor cashflows with (i) future asset returns, and (ii) past asset returns. Both correlations tend to alter the dollar-weighted return, but only the first affects investors’ expected wealth. The second generates a hindsight bias. This paper also derives a method which separates these two effects. The results show that the great majority of the return differential for mainstream US equities has been due to hindsight bias, and very little due to bad investor timing. Dollar-weighted returns have been low because aggregate investment flows reflect past returns rather than future returns, and these low returns should not lead us to adopt correspondingly low estimates of the risk premium. The decomposition method which is derived here also has many applications in other fields where dollar-weighted returns are used, such as project finance and investment management.

Do Retail FX Traders Learn

What is the benefit of experience? Using data from a leading trading platform we find no evidence that retail FX traders learn to trade better, but they do appear to make valid inferences about their innate abilities as traders. In particular, following an unsuccessful trading day they are more likely to cease trading, to trade smaller amounts and to trade less frequently. These effects are stronger for younger and less experienced traders who might be expected to have more to learn than older, more experienced traders. As regards learning through experience, surprisingly we find that more seasoned traders demonstrate a slight decline in performance once we account for the endogenous decision to cease trading, and even very experienced traders consistently lose money.

Value Averaging and How Dynamic Strategies Bias the IRR and Modified IRR

Value averaging (VA) is a popular investment strategy which is recommended to investors because it achieves a higher IRR than alternative strategies. However, this paper demonstrates that this is entirely due to a hindsight bias which raises IRRs for strategies which like VA link the scale of additional investment to the returns achieved to date. VA does not boost profits – in fact it suffers substantial dynamic inefficiency. VA can generate attractive behavioural finance effects, but investors who value these are likely to prefer the simpler Dollar Cost Averaging strategy, since VA imposes additional direct and indirect costs on investors as a result of its unpredictable cashflows. JEL Classification: G10, G11 * Cass Business School , 106 Bunhill Row, London EC1Y 8TZ, UK. E-mail: simon.hayley.1@city.ac.uk. Tel +44 20 7040 0230. I am grateful to Stewart Hodges, Richard Payne, Giorgio Questa and Nick Ronalds for useful comments. The usual disclaimer applies.This paper demonstrates that the IRR is a biased indicator of expected profits for Value Averaging (VA) and for any other dynamic strategy which is based on a target return or profit level, or which takes profits or “doubles down” following losses. The modified IRR is similarly biased. VA is popular, but this paper demonstrates that it is an inefficient investment strategy (for any plausible investor risk preferences) and quantifies the resulting welfare losses. VA’s popularity appears to be due to investors making a cognitive error in assuming that the strategy’s attractive IRR implies greater expected terminal wealth.