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Where do returns come from?
I spent years pondering this question as the actual source of returns is remarkably disconnected, both temporally and quantitatively from the realization of returns. At first it seems like a simple question with a simple answer: Total return is measured by summing dividends and capital gains (realized and unrealized).
Sure, but where do capital gains and dividends come from?
Let me begin with looking at how market capitalization interacts with capital gains.
2 pathways for market cap expansion
There are 2 ways in which the market capitalization of a company increases:
- Equity issuance
- Price increase
The first is quite straight forward and it is easy to track where the money is coming from. A company issuing 1 million shares at $10 per share is receiving actual cash inflows of $10 million (minus underwriting costs).
Thus, the $10 million rise in the market capitalization directly corresponds to $10 million more dollars invested in the company. However, shareholders now own a smaller portion of that company so such issuance does not directly create capital gains.
The market cap increase that happens when market price increases is a bit more nebulous.
Money out of thin air
The market cap of all U.S. equities is about $48 trillion. On any given day stock prices will move varying amounts but let us consider a 2% up day. Suddenly the market cap of all U.S. equities is about $49 trillion.
Where did that extra…
