Chapter 6: The Returns and Risks From Investing CHAPTER OVERVIEW The purpose of Chapter 6 is to present an analysis of risk

and return early enough in the text for these concepts to be used throughout the book. Return and risk are the key elements of investment decisions--in effect, everything else revolves around these two factors. t makes sense, therefore, to analy!e and discuss these concepts in detail. Chapter 6 focuses only on understanding and measuring reali!ed returns and wealth. This allows students to concentrate on this one issue, in a comprehensive manner. "ll of the e#uations for calculating various types of returns are included in this chapter, providing a complete package in this regard. t is doubtful that beginning students could need any more than what is contained here with regard to reali!ed returns. Chapter 6 provides a complement to Chapter $, which covers expected returns and risk and the basic calculations of portfolio theory. Thus, in Chapter 6 we analy!e and calculate reali!ed returns, while in Chapter $ we analy!e and calculate e pe!ted returns, based on probability distributions. This discussion centers around the definition and meaning of return and risk, including the components of return, the sources of risk, and types of risk. The emphasis is on how to both understand and measure return and risk. Considerable attention is devoted to explaining the tota" return %TR&, return re"ative %RR&, and !umu"ative #ea"th calculations, which are used throughout this text and are exactly comparable to the definitions used in such prominent sources as the Ibbotson Associates Yearbook. 'umerous examples of these important calculations are presented. The discussion of returns measures facilitates the presentation of the data on rates of return and wealth indexes. This data is both important %as benchmarks& and interesting %it can be the basis of lively class discussion&. The data used here were collected and calculated by the author, and correspond closely with the bbotson data. 63

The use of the geometric mean is fully explored, along with wealth indexes. Calculations include measuring the yield component and capital gains component of total returns and cumulative wealth separately, measures of inflation-ad(usted returns, and risk premiums. )efinitions of risk are presented and discussed. *xamples include calculations involving the standard deviation. The breakdown of total risk into a systematic part and a nonsystematic part is introduced in Chapter 6 to facilitate the discussion of market risk, portfolio diversification, and so forth. These concepts are treated in more detail in Chapter $, and in Chapters +, and -.. This chapter contains an extensive problem set. CHAPTER O$%ECTIVE&

To explain the meaning and measurement of both return and risk. To illustrate the use of such measures as the geometric mean and standard deviation. To present the well-known bbotson data on rates of return.

To present and illustrate virtually all the calculations needed for a thorough understanding of return and risk.

64

'A%OR CHAPTER HEA(I)*& +Contents, Return

The Components of Return /0ield1 Capital gain2loss1 total return 3 the sum of these two4

Risk

5ources of Risk /sources include6 interest rate1 market1 inflation1 business1 financial1 li#uidity1 exchange rate1 country4 Types of Risk /total risk can be divided into nonsystematic risk and systematic risk4

'easuring Returns

Total Return /definition1 examples4 Return Relative /definition1 example4 Cumulative 7ealth ndex /definition1 index4

Taking a *"o-a" Perspe!tive /definition1 index4

nternational Returns and Currency Risk /calculating foreign returns to 8.5. investors4 5ummary 5tatistics for Returns /arithmetic mean1 geometric mean1 comparisons4 nflation-"d(usted Returns /definition1 calculations4 65

'easuring Risk

5tandard )eviation /definition1 formula1 example4 Risk 9remiums /definition1 e#uity risk premium1 maturity premium4

Rea"i.ed Returns And Risk From Investing

Total Returns and 5tandard )eviations /linkage between arithmetic and geometric mean1 data on rates of return for ma(or asset classes4 Cumulative 7ealth ndexes /cumulative wealth figure1 inflation-ad(usted cumulative wealth1 the yield and price change components of cumulative wealth4

POI)T& TO )OTE A$O/T CHAPTER 6 Ta-"es and Figures *xhibit 6-+ should be reviewed carefully with students as examples of how to calculate total returns and return relatives for three different securities. Table 6-+ shows annual 5:9 ;.. data--prices and dividends-from +,+, through the latest year possible. Calculated total returns for each year are presented. This table provides a good source of data for discussions throughout the text involving market returns as measured by the 5:9 ;.. ndex. These data were calculated and compiled by <ack 7ilson and Charles <ones. Tables 6-- and 6-= involve the calculation and interpretation of the arithmetic and geometric means using TRs. t is suggested that instructors stress the meaning of the geometric mean.

66

Table 6-> %for historical data& shows calculations for the standard deviation and can be handled by students on their own or emphasi!ed by instructors to the extent thought necessary. Table 6-; is an important table on rates of return and should be used as a transparency for class discussion. This table is important for numerous reasons6 investors need to know the historical return series for benchmark purposes, it illustrates the nature of the return--risk tradeoff, and it allows you to talk about the variability in returns over time by analy!ing the arithmetic and geometric means as well as the standard deviations presented in the table. n addition, other points can be developed, such as the ?small@ stock effect, and so forth. )OTE6 This table corresponds #uite well with the comparable table from bbotson "ssociates. Aey differences include a start date at the end of +,+,, and the use of ;.. stocks instead of ,. stocks %which bbotson "ssociates uses& for a number of years. Bigure 6-+ shows the spread in returns for the ma(or financial assets covered in Table 6-;. "s we would expect, both stock categories have wider spreads than do bonds, and small stocks have a wider dispersion than does the 5:9 ;... Bigure 6-- shows cumulative wealth indices for the ma(or financial assets since +,+, and is a good source of class discussion because students find this interesting. nstructors may wish to emphasi!e how these values are calculated %which is covered in the chapter&. $o Inserts

Cox 6-+ is an interesting discussion from Business Week about the e#uity risk premium. The discussion concerns what the e#uity risky premium is, how to measure it, and what the controversy is all about. This boxed insert can provide a basis for good class discussion.

67

A)&WER& TO E)(0OF0CHAPTER 1/E&TIO)& 6023 Historical returns are reali!ed returns, such as those reported by bbotson "ssociates. Expected returns are ex ante returns--they are the most likely returns for the future, although they may not actually be reali!ed because of risk. 6043 " Total Return can be calculated for any asset for any holding period. Coth monthly and annual TRs are often calculated, but any desired period of time can be used. Tota" return for any security consists of an income (yield) component and a capital gain (or loss) component. D The yield component relates dividend or interest payments to the price of the security. D The capital gain %loss& component measures the gain or loss in price since the security was purchased.

6053

7hile either component can be !ero for a given security over a specified time period, only the capital change component can be negative. 6063 TR, which is another name for ho"ding period 7ie"d, is a percentage return, such as E+.F or -+;F. The term ?holding period return@ is sometimes used instead of TR. Return re"ative adds +.. to the TR in order that all returns can be stated on the basis of +.. %which represents no gain or loss&, thereby avoiding negative numbers so that the geometric mean can be calculated&. 6083 The geometri! mean is a better measure of the change in wealth over more than a single period. Gver multiple periods the geometric mean indicates the compound rate o return, or the rate at which an invested dollar grows, and takes into account the variability in the returns. The geometric mean is always less than the arithmetic mean because it allows for the compounding effect--the earning of interest on interest. 68

6063

The arithmeti! mean should be used when describing the average rate of return without considering compounding. t is the best estimate of the rate of return for a single period. Thus, in estimating the rate of return for common stocks for next year, we use the arithmetic mean and not the geometric mean. The reason is that because of variability in the returns, we will have to average the arithmetic rate in order to achieve a rate of growth which is given by the smaller geometric mean. 5ee *#uation 6-+>. Anowing the arithmetic mean and the standard deviation for a series, the geometric mean can be approximated. "n e#uity risk premium is the difference between stocks and a risk-free rate %proxied by the return on Treasury bills&. t represents the additional compensation, on average, for taking the risk of e#uities rather than buying Treasury bills. "s Table 6-; shows, the risk %standard deviation& of all common stocks for the +,-.--... period was -..$F, about two and one-half times that of government and corporate bonds. Therefore, common stocks are clearly more risky than bonds, as they should be since larger returns would be expected to be accompanied by larger risks over long periods of time. 'arket risk is the variability in returns due to fluctuations in the overall market. t includes a wide range of factors exogenous to securities themselves. $usiness risk is the risk of doing business in a particular industry or environment. nterest rate risk and inflation risk are clearly directed related. nterest rates and inflation generally rise and fall together.

6093

60:3

60;3

602<3

60223

&7stemati! risk6 market risk, interest rate risk, inflation risk, exchange rate risk, and country risk. )ons7stemati! risk6 li#uidity risk. business risk, financial risk, and

69

60243

Countr7 risk is the same thing as po"iti!a" risk. t refers to the political and economic stability and viability of a countryHs economy. The 8nited 5tates can be used as a benchmark with which to (udge other countries on a relative basis. Canada would be considered to have relatively low country risk although some of the separation issues that have occurred there have probably increased the risk for Canada. Iexico seems to be on the upswing economically, but certainly has its risk in the form of nationali!ed industries, overpopulation, and other issues. Iexico also experienced a dramatic devaluation of the peso.

63253

The return on the <apanese investment is now worth less in dollars. Therefore, the investorHs return will be less after the currency ad(ustment. *J"I9K*6 "ssume an "merican investor on the <apanese market has a =.F gain in one year but the 0en declines in value relative to the dollar by +.F. The percentage of the original investment after the !urren!7 risk is accounted for is %..,&%+=.F& 3 ++$F. Therefore, the investorHs return is +$F, not =.F. n effect, the investor loses +.F on the original wealth plus another +.F on the =.F gain, or a total of += percentage points of the before-currency-ad(ustment wealth of +=.F of investment.

60263

Risk is t!e c!ance t!at t!e actual outcome rom an in"estment #ill di er rom t!e expected outcome. Risk is often associated with the dispersion in the likely outcomes. )ispersion refers to variability, and the standard deviation is a statistical measure of variability or dispersion. &tandard deviation measures risk in an absolute sense. $eta is a relative measure of the risk of an individual security in relation to the overall market, which has a beta of +... Cetas have intuitive meaning only in relation to the benchmark of +.. for the market beta.

70

60283

" wealth index measures the cumulative effect of returns over time, typically on the basis of L+ invested. t measures the level rather than changes in wealth. The geometric mean is the nt! root of the wealth index. "lternatively, adding +.. to the decimal value of the geometric mean and raising this number to the nt! power produces the ending wealth index.

60263

0ou cannot validly compare a $,-year mean return with recent return figures because of inflation premiums. The expected return on common stocks may be higher than the !istorical reali!ed mean because of a higher inflation premium %at a minimum&. The proper comparison is either between the historical returns on both stocks and bonds or the current expected returns on both stocks and bonds. )ividing the geometric mean return for common stocks by the geometric mean for inflation for a given period produces the inflation-ad(usted rate of return. The two components of the cumulative wealth index are the yield %income& component and the price change %capital gain or loss& component. Iultiplying these two components together produces cumulative wealth. Anowing one of these components, the other can be calculated by dividing the known component into the cumulative wealth index number. 'o. These relationships are not linear, nor is there any reason why they should be. The risk on common stocks relative to bonds has been more than twice as great. This means that a loss occurred. "n index number less than +.. connotes a loss. The capital gain component for bonds over very long periods of time has, in fact, been less than +.., indicating a negative rate of return. $urc!asing po#er risk is the risk of inflation reducing the returns on various investments. Gne should look at the total return of e#uities on a price level ad(usted basis.

60293

602:3

602;3

604<3

CFA 60423

71

Interest Rate Risk is a rise in the level of interest rates that depresses the prices of fixed income instruments and fre#uently causes lower prices for e#uities. nterest rate volatility and uncertainty are both relevant. Business Risk includes the risks associated with the business cycle. 5tock prices tend to go down in anticipation of a downturn in the business cycle. Bactors affecting the business cycle include the impact of monetary policy, changes in technology, changes in supply of raw materials. "ttempting to correctly forecast the turning point in a business cycle and the factors that affect a business cycle can reduce the business risk. %arket Risk is the general risk associated with fluctuations in the stock market. 7hen the stock market declines, most stocks go down. 7hile a low beta for a stock or a defensive stock position may reduce the volatility, the stock market has a pervasive influence on individual stocks. Exc!ange rate risk is the potential decline in investment value due to a decline in the currency in which the shares or bonds are held. Regulatory risk is the risk of an unanticipated change in the regulation of factors that affect investments such as changes in tax policy. $olitical risk is the unanticipated change in investment environment due to a change in political parties or a change of view of the current political party.

72

A)&WER& TO E)(0OF0CHAPTER PRO$=E'& 6023 8sing CI data from )emonstration 9roblem 6-+6 capital gain %loss& -L+..=. =.>. -++... =,.;; -;.$; total L return -L6.M6 6.M> -$.;6 >-.,, -,.>6

0ear +,J+ +,J+,J= +,J> +,J;

TR for +,J= 3 %L=.>> E %L;6.$. - L6$.$.&&2L6$.$. 3 -.+++$ or -++.-F TR for +,J> 3 %L=.>> E %L,6.-; - L;6.$.&&2L;6.$. 3 .$;M- or $;.MF 'GT*6 These two years %actual +,$= and +,$> returns& were chosen specifically for their contrast. This is a good opportunity for instructors to point out how TRs for even a blue chip company such as CI have fluctuated violently from year-to-year. This shows dramatically the risk of common stocks as well as the opportunities for large returns. 6043 This investor would have a %short-term& capital gain, with a tax liability of L;... - L>... 3 L+... %.-M& 3 L-M. 6053 Calculating Total Returns %TRs& for these assets6 %a& TRps 3 %)t E %9* - 9C&&29C 3 the preferred dividend 3 ending price or sale price 3 beginning price or purchase price 3 %; E -$&2$. 3 --.M6F 3 %Ct E 9C&29C

where )t 9* 9C TR %b& TRw

where Ct is any cash payments paid none for a warrant& 9C TR

%there are

3 price change during the period 3 %. E -&2++ 3 +M.+MF for the three month period

%c&

TRb

3 %

E 9C&29C

3 %->.N E 6.&2M$. 3 =>.;F for the two year period. Ninterest received is L+-. per year %+-F of L+...& for two years. Calculating Return Relatives %RRs& for these examples6 %a& %b& %c& 6363 a TR of --.M6F is e#ual to a RR of .,$+> or %+..E /-..-M64& a TR of +M.+MF is e#ual to a RR of +.+M+M a TR of =>.;F is e#ual to a RR of +.=>;

Calculate future values using tables at end of text6 O+-F L+.. L+.. L+.. L+.. %+.$6-& %=.+.6& %,.6>6& %-,.,6& 3 3 3 3 L+$6.-. after ; years L=+..6. after +. years L,6>.6. after -. years L-,,6... after =. years

Calculate present values using tables at end of text6 O+-F L+.. L+.. L+.. L+.. 6083 %a& %.;6$& %.=--& %.+.>& %..==& 3 3 3 3 L;6.$. L=-.-. L+..>. L=.=. after after after after ; years +. years -. years =. years

The arithmetic rate of return is /.=+>M E %>.M>$& E -..=6$ E --.=+- E ;.,66 E =+..;$426 3 +$.$-

The geometric mean rate of return for the 5:9 ;.. Composite ndex for +,M.-+,M; %from Table 6-+& is6 P 3 %+.=+>M x .,;+;= x +.-.=6$ x +.--=+- x +..;,66 x +.=+.;$&+26 - +.. 3 %-.;;$,+++&+26 - +.. 3 +.+6,> - +.. 3 .+6,> or +6.,>F 6063 Refer to *#uation 6-+- for the standard deviation formula. 7e will use n-+ in the calculation. 0ear +,M. +,M+ +,M+,M= +,M> +,M; TR%F&,J =+.>M. ->.M>$ -..=6$ --.=+;.,66 =+..;$ QQQQQQQ +.6.==; R J 3 +$.$--; +.>-.$=--2; 3 -.M.;>6> 3 variance %-.M.;>6>&+2- 3 +>.>>F 6393 L+..%+.=+>M&%.,;+;=&%+.-.=6$&%+.--=+-&%+..;,66& %+.=+.;$&%+.+M;=,&%+..;66;&%+.+6==,&%+.=+--,& 3 >.M,+>. %>.M,+>.&+2+. 3 +.+$-.> J-J +=.$;$; ---.;6,; -.6>>; >.;M,; -++.$;6; +=.==>; %J-J&+M,.-6MM ;.,.=M-= 6.,,=> -+..6=; +=M.-+;= +$$.M.M, QQQQQQQQQ +.>-.$=--

+.+$-.> - +.. 3 .+$-.> or +$.-.>F 63:3 There are $, years for the period )ec. +,+, through )ec. +,,M. Cumulative wealth 3 %+.+.,M&$, 3 L=,$;-.6+ "llowing for rounding, this agrees with the number shown in Bigure 6-- for the 5:9 ;.. ndex.

63;3

"ccording to Table 6-;, the geometric mean for government bonds for the period +-2+,+, through +-2+,,M was ;.>6=6. Cumulative wealth 3 %+..;>6=6&$, 3 L66.M;.;

602<3

%+..;&6M 3 -$.6. 'GT*6 the data starts at the beginning of +,-61 therefore, there are 6M years, or %+,,= - +,-6& E + This problem provides some practice for periods other than $, years.

60223 63243

%,;.M>&+2$, 3 +..;,;1 +..;,; - +.. 3 ;.,;F Birst, raise =... to the $=th power %+-2+,-;S +-2+,,M&1 %+..=..&$= 3 M.6;5econd, divide nominal cumulative wealth by the cumulative inflation index. +=,-,=.+> 2 M.6;- 3 +,;=6.>- 3 inflation-ad(usted C7 for small common stocks, +,-6-+,,M.

60253

%,2+&+2$> 3 +..=.+ +..=.+ - +.. 3 ..=.+ or =..+F 'GT*6 Bor this problem, there are $> years.

60263

%+..>>6&$, 3 =+.>+ 3 cumulative wealth index for the yield component Brom Bigure 6--, =,$>+.=$ is the cumulative wealth index value for stocks at the end of +,,M. =,$>+.=$ 2 =+.>+ 3 ++,.++ 3 cumulative wealth index value for the capital gain component 'GT*6 =+.>+ J ++,.++ 3 =,$>+.=$

60283

Gbviously, we must put the two components of cumulative wealth on the same basis. Converting

the geometric mean for the yield component to cumulative wealth, we have %+..=,&6M 3 +=.>M;Cumulative wealth index 3 +=.>M;- x +,$.+. 3 L-,6;$.,= The C7 for this %or any other financial asset& series is the product of the two components. 63263 The two ways to calculate inflation-ad(usted returns are6 +. -. +..;>6 2 +..-6- 3 +..-$6$;1 %+..-$6$;&$, 3 M.6>%+..;>6&$, 3 66.6$.;1 %+..-6-&$, 3 $.$+>,1 66.6$.;2 $.$+>, 3 M.6>60293 8sing some type of statistics package6 *nter the ; TRs from Table 6-+ for the years +,-$- +,=+. 8se minus signs as necessary and round the returns to two decimal places. The program should calculate the geometric mean as ->.>6F. Anowing that the ending wealth index for +,=+ is ..$,;,+, the same result can be obtained by calculating the geometric mean. Taking the fifth root of the wealth index using a calculator produces a result of .,;;, which is a geometric mean of ->.>6F. 602:3 "ny set of TRs that are identical will produce a geometric mean e#ual to the arithmetic mean1 for example, +.F, +.F and +.F, or any other set of three identical numbers. The calculated results are6 "rithmetic Iean 5tandard )eviation Peometric Iean +;.$$F +=.+;F +;..$F

602;3

"s we can see, the standard deviation for the shorter period was less than that of the entire period. This is because of the good years in the +,M.s that were more similar than in a typical +. or

++ year period. "lso, there were only two negative years during this period, whereas the historical norm for many years was = negative years out of +. %this has not occurred in the +,,.s&. 604<3 8sing whatever stat package is available should verify that the standard deviation is calculated as +,F. Changing the +,$; value from =6.,- to -6.,- changes the standard deviation from +,F to +$.>MF. This is obviously because the dispersion is reduced. This value moves closer to the mean. 60423 60443 60453 %+.++&$, 3 L=,M.6.>+ %+..;,&$, 3 L,-.6> *nding wealth for small common stocks sin!e the -eginning o> 2;46 %when the data for small stocks begins in Table 6-;&6 L+... %+.+-M&$= 3 L+... %6,;M;.+=& 3 L6,;M;.+= *nding wealth for the 5:9 ;.. sin!e the -eginning o> 2;46 6 C7 3 L+%+.++&$= 3 L-,.=;..6

The difference between ending wealths for all common stocks %the 5:9 ;..& and ?small@ common stocks is a result of the power of compounding the roughly two percentage points difference between the two series over a $= year period. 'ote the difference in the C7 for the 5:9 ;.. between #uestion 6--+, where the data start in +-2+,+, %$, years&, and 6--=, where the date begin in +-2+,-; %$= years&. &uc! is t!e po#er o compounding. 63463 The capital appreciation index for common stocks means6 a. Relative to the beginning point at the end of +,+,, L+... invested in stocks at the geometric

mean annual rate of return for capital appreciation of 6.-=>F would have accumulated to approximately L++M.$M by the end of +,,M. The geometric mean is calculated by taking the $,th root of ++M.$M. b. The total return index is composed of the capital appreciation index and the income index %dividend yield&. Anowing the ending values of each of the two components, we can calculate the total return index. Anowing the C7 for stocks is =$>+.=$, we can calculate the C7 for the yield component, given the C7 of ++M.$M for the capital appreciation component %it is =+.>,M&. Comparing the si!e of each of the two components would indicate which contributed more to total return--in this case, the capital appreciation component, as shown below. 60483 Anowing these two items, the total return or cumulative wealth index and the capital appreciation index, we can calculate the other component of total return. a. b. The other component is the dividend yield or income component. " total return index for common stocks of =$>+.=$ and a capital appreciation index of ++M.$M implies an ending wealth for the income component of =+.>,M %=$>+.=$ 2 ++M.$M&, or a geometric mean of >.>6F. Capital gains have been more important than the income component, given the 6.-=F vs. >.>6F geometric means. Towever, the importance of the dividend component may surprise some students because they think of common stocks primarily for the capital appreciation. n fact, the dividend component of common stocks is a very important component, as these geometric means show. Burthermore, the capital gains component has gotten larger only in the last few years as the dividend component declined in importance. Tistorically, the two

c.

were much closer together in si!e, although the capital gains component has typically been the larger to the two. The emphasis here should be on the importance of the dividend component over time. 60463 Anowing two wealth index values, we can compute the rate of return involved. n this case, /6$;.;,- 2 ;+$.>>,4 - +.. 3 annual rate of return 3 +.+. - +.. 3 =..;6F return for +,,+. 60493 Piven a ..M$ capital appreciation index for longterm governments and the table in the problem set, a. b. ending wealth 3 L+... %+..;;&$, 3 6M.6,M %..M$&+2$, 3 ..,,M- 3 -....+M 3 -..-F Returns for capital appreciation alone amounted to a decrease in the L+... at the beginning of +,-. to M$ cents at the end of +,,M. This is a compound annual negative growth rate of -..-F. c. The income component accounted for all of the total return, which would have been higher if the capital appreciation component had not existed.

604:3

"s of the end of +,,M, using data in the table given, the ending number for inflation was %-.6&$,, or $.;,$. This means that L+... of consumer goods measured in the C9 would have cost L$.6. by the end of +,,M. Gbviously, the content of any consumer goods basket has changed over time. The real total return index for common stocks can be calculated by dividing the ending wealth for common stocks by the ending number for inflation, or =$>+.=$ 2 $.6. 3 >,-.-, Therefore, on an inflation-ad(usted basis, L+... invested in stocks at the beginning of +,-. would have grown to L>,-.-, by the end of +,,M.

604;3

605<3

The geometric mean annual real rate of return on common stocks is6 %>,-.-,&+2$, - +.. 3 ..M+6 or M.+6F.

60523

Bor corporates, %+..=-&$, 3 +-..>- for t!e in lation' ad(usted cumulative wealth index. This compares to the in lation'ad(usted cumulative wealth index of >,-.-, for stocks. The difference between the two is caused by the variability in the returns. The greater the variability in the return series, the greater the difference in the two means. The linkage between the geometric mean and the arithmetic mean is given, as an approximation, by *#uation 6-+>. %+ E P& %+ E ".I.&- - %5.).&-

60543

where P 3 the geometric mean of a series of asset returns ". I. 3 the arithmetic mean of a series of asset returns 5. ). 3 the standard deviation of the arithmetic series of returns++ Thus, if we know the arithmetic mean of a series of asset returns and the standard deviation of the series, we can approximate the geometric mean for this series. "s the standard deviation of the series increases, holding the arithmetic mean constant, the geometric mean decreases. 8sing the data given in 9roblem 6-=- for common stocks6 %+ E P&- %+ E P&- %+ E P&- P %+.+;&- - %.;.&+.=--; - .-;.. +..$-; =.;6F

n this example, the very high standard deviation for this category of stocks results in a very low

geometric mean annual return despite the high arithmetic mean. Uariability mattersV 60553 Rankings on the basis of both return and risk would be expected to be6 %+& %-& %=& Cergstrom Capital "dams *xpress '" nvestment 5ecurities

Peneral corporate bond funds would be expected to have less risk and return than e#uity funds. 5ince Cergstrom Capital is seeking capital appreciation, it would be expected to have a greater risk, and a higher average return, than "dams *xpress. 60563 '" nvestment Capital "dams *xpress Cergstrom

+ year perf. = + RRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRRR = year avg. = + ; year avg. = + +. year avg. = + These are the actual rankings in terms of performance. Gver =, ;, and +. year periods the two e#uity funds outperformed the bond fund, and the more risky e#uity fund outperformed the less risky. This obviously does not have to be the case for any of these time periods, and certainly not for the one year period when, in fact, the rankings did not match those for longer periods. The rankings for other funds of a similar nature might be different. Gver longer periods, we would typically expect these rankings to hold. 5tudents cannot be expected to know the actual rankings, and one could make a case for various rankings over different periods. Anowing nothing else, however, it would be reasonable to rank the funds on an a priori basis the same as the actual performance turned out to be--the bond fund last, the fund seeking capital appreciation in the middle, and the aggressive fund at the top.

60583 Iean 5td. )ev. Peo. Iean 60563

'" +..$=F ++.;> +..+,

"dams +M.6>F +>.M= +$.$,

Cergstrom -M.M+F =-.>> -;.=M

5:9 +6.=>F +=..= +;.6;

'o, '" nvestment is a bond fund, and the 5:9 ;.. is a stock index. 7e should not be mixing bond fund returns and the 5:9 ;.. together. The ending wealth index for +,M.-+,,- starting with L+... on +2+2M. is6 '" "dams Cergstrom 5:9 ;.. =.;= M.>. +M.,= 6.6-

60593

"s we might expect, the ending wealth for the bond fund is considerably less than the ending wealth for the stock funds. 605:3 The geometric mean returns are6 "dams Cergstrom 5:9 ;.. +,M.-+,,5:9 ;.. +,-6-+,,+$.$,F -;.=MF +;.6;F +..=F

This analysis clearly shows that the +,M.s %including here through +,,-& was one of the great periods to own common stocks. The 5:9 ;.. during this period had a high geometric mean average relative to the entire $. year period examined in the previous problem set, and the two stock funds outperformed the market. The returns for Cergstrom are obviously #uite extraordinary, with money compounding at the rate of -;F a year during this +=-year period.