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Time 0 1
Percentage Returns
–the sum of the cash received and the
Initial change in value of the asset divided by
investment the initial investment.
Dollar Return = Dividend + Change in Market
Value
dollar return
percentage return
beginning market val ue
$3,000
Time 0 1
Percentage Return:
$520
-$2,500 20.8% =
$2,500
The holding period return is the
return that an investor would get
when holding an investment over a
period of n years, when the return
during year i is given as ri:
holding period return
(1 r1 ) (1 r2 ) (1 rn ) 1
Suppose your investment provides
the following returns over a four-
year period:
( R1 R) 2 ( R2 R) 2 ( RT R) 2
SD VAR
1
the frequency distribution of theTreturns
Average Standard
Series Annual Return DeviationDistribution
– 90% 0% + 90%
Source: © Stocks, Bonds, Bills, and Inflation 2006 Yearbook™, Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson
and Rex A. Sinquefield). All rights reserved.
The Risk Premium is the added return (over and
above the risk-free rate) resulting from bearing risk.
One of the most significant observations of stock
market data is the long-run excess of stock return
over the risk-free return.
The average excess return from large company common
stocks for the period 1926 through 2005 was:
8.5% = 12.3% – 3.8%
The average excess return from small company
common stocks for the period 1926 through 2005 was:
13.6% = 17.4% – 3.8%
The average excess return from long-term corporate
bonds for the period 1926 through 2005 was:
2.4% = 6.2% – 3.8%
Suppose that The Wall Street Journal announced
that the current rate for one-year Treasury bills
is 5%.
What is the expected return on the market of
small-company stocks?
Recall that the average excess return on small
company common stocks for the period 1926
through 2005 was 13.6%.
Given a risk-free rate of 5%, we have an
expected return on the market of small-
company stocks of 18.6% = 13.6% + 5%
18%
Small-Company Stocks
16%
Annual Return Average
14%
8%
6%
T-Bonds
4%
T-Bills
2%
0% 5% 10% 15% 20% 25% 30% 35%
Annual Return Standard Deviation
There is no universally agreed-upon
definition of risk.
The measures of risk that we discuss
are variance and standard deviation.
The standard deviation is the standard statistical
measure of the spread of a sample, and it will be the
measure we use most of this time.
Its interpretation is facilitated by a discussion of the
normal distribution.
A large enough sample drawn from a normal
distribution looks like a bell-shaped curve.
Probability
– 3s – 2s – 1s 0 + 1s + 2s + 3s
– 48.3% – 28.1% – 7.9% 12.3% 32.5% 52.7% 72.9% Return on
large company common
68.26% stocks
95.44%
99.74%
The 20.2% standard deviation we
found for large stock returns from
1926 through 2005 can now be
interpreted in the following way: if
stock returns are approximately
normally distributed, the probability
that a yearly return will fall within
20.2 percent of the mean of 12.3%
will be approximately 2/3.
Year Actual Average Deviation from Squared
Return Return the Mean Deviation
1 .15 .105 .045 .002025
T 1 N T
R(T ) GeometricA verage Arithmetic Average
N 1 N 1
where, T is the forecast horizon and N is the number of
years of historical data we are working with. T must be
less than N.
Which of the investments discussed has had
the highest average return and risk premium?
Which of the investments discussed has had
the highest standard deviation?
Why is the normal distribution informative?
What is the difference between arithmetic and
geometric averages?