Hal Varian writes,

An investor who bought a value-weighted portfolio of stocks in the New York Stock Exchange and American Stock Exchange in 1926 and held them until 2002 would have earned an average annual return of about 10 percent.

By contrast, an individual who bought in 1926 but moved his dollars in and out of the market in the same pattern as the average dollar invested in the market would have earned a return of only 8.6 percent a year.

He cites this paper by Ilia D. Dichev, which appeared in the American Economic Review in March. I remember seeing the paper, and I remember being completely baffled by it.

I rely a lot on intuition. I make up simple, numerical examples to illustrate problems, and sometimes I mess up. I get misled by my own examples, and then somebody needs to correct me. In this case, let us start with an example Varian uses.

To understand the difference between a stock’s return and an investor’s return, consider someone who buys 100 shares of a company at a price of $10 a share. A year later, the share price is up to $20, and the investor buys 100 more shares.

Alas, the investor’s luck has run out. By the end of the next year, the price has fallen back to $10 and the investor sells his 200 shares.

A buy-and-hold investor who bought at $10, held the stock for two years, and then sold at $10 would have had a zero return.

But our friend who tried to time the market did much worse: over the two years, he invested $3,000 in the stock and ended up with only $2,000.

Fair enough. But who did our friend trade with? If I sold to our friend 100 shares at $10, then sold another 100 at $20, then bought them all back at $10, then I made $1000. In the aggregate, our friend and I broke even, which is what the stock did.

My intuition tells me that for every buyer there is a seller. So I do not understand how trading profits and losses do not cancel out in the aggregate. If they do cancel out, then investors as a whole end up earning the market rate of return.

In this case, my intuition blocked me from understanding the paper. This is one of those cases where I need help straightening out my intuition.

UPDATE: Some commenters, including the author of the paper, help to clarify. It sounds as though firms float new stock when prices are high and buy back stock when prices are low.

My first reaction to the comments (and I admit to being heavily medicated at the moment, due to allergies) is to think, well, ok, companies earn trading profits against individuals. But, then, individuals own companies. If I own 100 shares of XYZ, XYZ floats 10 shares that you buy for $100, then XYZ buys them back from you for $50, your loss is in some sense my gain. The point may be that my gain gets counted in the return to shareholders, but your loss does not, unless we dollar-weight returns. In that case, unweighted returns overstate the rate of return.