Reconsidering Returns

Samuel M. Hartzmark and David H. Solomon
NBER Working Paper No. 27380
June 2020

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ABSTRACT Investors' perception of performance is biased because the relevant measure, returns, is rarely displayed. Major indices ignore dividends thereby underreporting market performance. Newspapers are more pessimistic on ex-dividend days, consistent with mistaking the index for returns. Market betas should track returns, but track prices more than dividends, creating predictable returns. Mutual funds receive inflows for “beating the S&P 500,” price index based on net asset value (also not a return). Investors extrapolate market indices, not returns, when forming annual performance expectations. Displaying returns by default would ameliorate these issues, which arise despite high attention and agreement on the appropriate measure.

What Is Wrong with this Picture? A Problem with Comparative Return Plots on Finance Websites and a Bias Against Income-Generating Assets

Agrrawal, Pankaj and Borgman, Richard
Journal of Behavioral Finance
ISSN: 1542-7579
Volume: 11, Issue: 4
Publisher: Taylor & Francis
London 2010

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ABSTRACT This paper brings to light and discusses a systemic issue in the calculation and display of relative return information as currently seen on some of the most prominent finance websites; income-generating events such as dividends and interest are not included in relative return calculations and all comparative return graphics. The resulting ranking of the securities, based on such incomplete returns, is essentially meaningless from a total return perspective, yet they are being served to millions of investors every day. This could lead to the formation of a possible availability heuristic and an optical bias against fixed-income and other income generating assets. This problem has gone unnoticed for many years with no discussion of the topic either in the academic or practitioner press. The ready availability of such unclear or inaccurate information from sources generally perceived to be credible can, in this age of do-it-yourself portfolio management, have serious and damaging financial consequences to the unsuspecting investor. The paper also shows the effect of this return differential on the calculation of the asset correlation matrices and the subsequent effect on the resulting asset-weight vectors that are used to generate Markowitz style mean-variance portfolios. The visual discrepancies are then supported by the application of the Gibbons, Ross and Shanken [1989] W-test for portfolio efficiency. The authors' proposed correction, based on elementary finance, fixes the problem.

“So, the S&P is up a healthy 7.5% since January 1. The Dow is up a more modest 2.6%. But here's the catch: those numbers are actually understating the market's true performance by a half-point or so. And this always happens. Why? Because that price performance doesn't include dividends, which actual investors who own the indexes get to pocket--or more crucially, reinvest. ”

4. FINRA Rule 5330

The Financial Industry Regulatory Authority (FINRA) has a Rule 5330 (5330. Adjustment of Ordersfinra.org) that requires broker-dealers to be fair to buyers by adjusting the price overnight downward by the amount of the dividend to be paid BECAUSE, as of that morning, the new buyers will no longer get the dividend. Therefore, the price they pay should be reduced by the dollar amount of the dividend. Here are the key points of the rule:

Ex-Dividend, Ex-Rights, Ex-Distribution, and Ex-Interest (Ex refers to Excluding): When a security is quoted ex-dividend, ex-rights, ex-distribution, or ex-interest, broker-dealers must adjust open orders accordingly.

The adjustment involves reducing, increasing, or adjusting the price and/or number of shares of the order.

For Cash Dividends: ...Open order prices are first reduced by the dollar amount of the dividend...

Adherence to Rule 5330 by broker-dealers ensures fair treatment of investors and maintains market integrity.

There are 3 dates important for dividends:

1) Date of Declaration: The date of declaration is when the company's board of directors announces their intention to pay a cash dividend.
2) Date of Record (and ex-dividend date): The date of record is how the company determines which shareholders are entitled to the dividend.
3) Date of Dividend Payment.

Here is an example of how it works:

1. Let's say a stock will pay a $5 dividend on Wednesday to all shareholders as of Monday and the stock had a closing price of $100 on Monday. At that point the buyers paid the equivalent of $95 for the stock and $5 for the cash dividend.
2. Tuesday is "excluding-dividend day" and, according to FINRA Rule 5330, the price will be adjusted overnight so that the opening price is adjusted to $95 (because those new buyers will not get the $5 dividend).
3. Wednesday is the date the $5 dividend is paid to all shareholders who owned the stock on the close of the market on Monday. Those shareholders did not lose $5 as it would appear by looking at the price only, so that $5 must be added back to the price to determine their return on their investment.

Because FINRA requires broker-dealers to reduce the daily opening price for buyers who won't get a dividend, they should also require the media to display an index that adds back that dividend on the day the price was reduced. Instead, the media shows a price-only index that declines when dividends are paid by the amount of those dividends, which is a wrong measure of total performance since the investor did received dividend and that dividend is a component of their total return.

5. S&P 500 Annual Return Breakdown(permalink)

Sample of Data:

Data Details: Detailed S&P 500 return data broken down into price, dividend, and total returns by year. The price return represents the return generated by price changes in the S&P 500 index. The return from reinvesting dividends distributed by the companies in the index is labeled as the dividend return. Total return is the sum of the price return and dividend return.

6. Links to SP Global where you can switch between Price Return and Total Return:(permalink)

• Default = Price Return: DOW
• Default = Price Return: S&P 500
• Default = Price Return: S&P 500 High Dividend Index
• Default = Price Return: S&P/ASX 200
• Default = Total Return: S&P U.S. Aggregate Bond Index
• Default = Total Return: S&P Target Date 2065+ Index
• Default = Total Return: S&P Target Date 2025 Index

7. Jason Zweig articles on the problems of Price-Only returns:(permalink)

• https://jasonzweig.com/heres-one-way-to-beat-the-market/
• https://jasonzweig.com/why-we-cant-tell-if-the-market-is-half-empty-or-half-full/

8. Dow Jones Industrial Average: Total Return vs Price Return(permalink)

9. Total Return vs Price-Only Return:(permalink)

10. Return Explanations:(permalink)

11. Proposal for Morningstar.com(permalink)

12. Proposal for SeekingAlpha.com(permalink)

13. Investopedia - Total Return Index: Definition, Example, Vs. Price Index - By James Chen:(permalink)

14. Indexology® Blog - Index Basics: Calculating an Index's Total Return - By Reid Steadman:(permalink)

15. Bloomberg Indicies using Total Return:(permalink)

16. Wall Street Journal: Lessons From a Three-Decade-Long Stock Market Disaster(permalink)

"Dividends are vital. Over the long run, the compounding effect of reinvesting dividends makes a huge difference to returns. In the past half-century, U.S. stocks turned $100 into $6,200 without dividends (ignoring costs and taxes) while with dividends they would be worth $25,000. The same is true in Japan, where the 2% yield from dividends is now much higher than in the U.S. An investor who made the dire decision to buy at the top of the bubble and reinvest dividends made back all losses by March 2021. Somehow we forgot to hold a party."