Fooled by Compounding

Abstract

Compounding can make things appear to be larger than they really are. This confusion can arise when the return from an event is compounded over a long holding period, and the return from compounding is described as the return from the event. In this article, McLean reviews several examples of this common mistake, which are found in a popular book on rare events, newspaper articles, investment advisors’ research reports, and finance journal articles. He also shows how compounding can distort inference in event studies and in the measurement of mutual fund performance. McLean describes alternative methods of return measurement that are not affected by compounding and shows that these methods can lead to different inferences than do measures that include compounding.

TOPICS: Portfolio management/multi-asset allocation, accounting and ratio analysis, statistical methods