What volatility do investors experience?

Individual investors have a hard time keeping up with the professionals. The annual review of the buy and hold returns of funds by Morningstar in comparison to the realised return of investors buying these funds shows a persistence underperformance of the individual investors vs. a simple buy and hold strategy. The reason is simple: investors tend to buy and sell at the wrong time and destroy performance by chasing past returns and selling past losers.

But the situation gets even worse because individual investors not only experience lower returns but likely also higher volatility. Ilya Dichev and Xin Zheng tried to identify what kind of volatility individual investors really experienced. In order to do that, they relied on simulations of dollar-weighted returns of individual stocks and portfolios compared to buy and hold total returns. So, we have to take their results with a grain of salt because it makes some assumptions about the capital flows of individual investors vs. fund managers. 

The key assumption of their simulation is that individual investors do not reinvest the dividends they receive in the stock that paid the dividend. Arguably that is a pretty reasonable assumption because most individual investors who manage their own portfolios do not reinvest their dividends, while many funds systematically reinvest dividends earned (unless they are share classes which pass through dividend income to investors). The second assumption is that if a company raises capital by issuing new shares then individual investors participate in that capital increase in proportion to their existing holdings. Similarly, if a company pays a share dividend, the individual investors are assumed to participate in the share offering in proportion to the dividend they earn. This second assumption is less realistic in my view because many individual investors typically don’t participate in capital increases.

Keeping these caveats in mind, the results are still interesting. First, they looked at the realised volatility of individual investors who invest in just one stock for investment periods of 10 or 20 years. This is a situation that many founders, owners, and senior managers of listed companies face with much if not all of their liquid wealth concentrated in one stock. The chart below shows that for every country the tested, the volatility experienced by the investor was significantly higher than the volatility experienced by a buy and hold investor who reinvests all dividends, etc.

Buy and hold vs. realised volatility for a 20-year investment horizon in a single stock

Source: Dichev and Zheng (2020).

Then they assumed an individual investor would invest in a portfolio of 50 stocks for 20 years and found pretty much the same result (Note that the volatility levels are much lower than for the individual stock case and lower than what you might expect, because the chart shows 20-year holding period volatility which is much lower than one-year volatility, thanks to mean reversion in stock returns).

Buy and hold vs. realised volatility for a 20-year investment horizon in a 50-stock portfolio

Source: Dichev and Zheng (2020).

And while these are simulation results, I think the lesson is clear. The power of automatically reinvesting dividends and avoiding taking money out of the portfolio is huge. It leads to higher returns and lower volatility.