Chapter 12

Some Lessons from Capital

Market History

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McGraw-Hill/Irwin

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

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This is called: The

Risk/Return Trade-off

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Risk, Return and

Financial Markets
Looking back through time we
know..
1. There is a reward for bearing
risk

2. The > the risk = the > the

potential return!
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The Importance of
Financial Markets

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The Importance of
Financial Markets
Financial markets also
provide us with
information about the
returns that are required
for various levels of risk

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Year-to-Year Total
Returns
Large-Company
Stock Returns
Long-Term Government
Bond Returns

U.S. Treasury Bill

Returns
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A Comparison of
Average Returns
Investment

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Average Return

Large Stocks

12.3%

Small Stocks

17.1%

Long-term Corporate
Bonds
Long-term
Government Bonds
U.S. Treasury Bills

6.2%

Inflation

3.1%

5.8%

3.8%

Now lets add risk to the

picture

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Risk Premiums
The extra return earned for taking
on risk
Treasury bills are considered to be riskfree
The risk premium is the return over
and above the risk-free rate
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Average Annual Returns

and Risk Premiums
Investment

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Average Return

Risk Premium

Large Stocks

12.3%

8.5%

Small Stocks

17.1%

13.3%

Long-term Corporate
Bonds

6.2%

2.4%

Long-term
Bonds

5.8%

2.0%

U.S. Treasury Bills

3.8%

0.0%

Dollar Returns
Total dollar return =
income from investment
+ capital gain (or loss) due to
the change in price
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What is my return?
You bought a bond for $950 one year ago.
You have received two coupons of $30
each.
You can sell the bond for $975 today.
What is your total dollar return?
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What is my return?
Income = 30 + 30 = 60
Capital Gain =
975 - 950 = 25
Total Dollar return =
60 + 25 = $85

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Percentage Returns
It is generally more
intuitive to think in
terms of percentage,
(rather than dollar),
returns
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Percentage Returns

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1.

Dividend Yield = income/beginning

price

2.

Capital Gains Yield = (ending price

beginning price) / beginning price

3.

Total percentage return = dividend yield +

capital gains yield

Percentage Returns

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You bought a stock

for $35.

You received
dividends of $1.25.

The stock is now

selling for $40.

Percentage Returns
1.

Dividend Yield = income/beginning

price
1.25 / 35 = 3.57%

2.

Capital Gains Yield = (ending price beginning

price) / beginning price
(40 35) / 35 = 14.29%

3.

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Total percentage return = dividend yield + capital

gains yield

3.57 + 14.29 = 17.86%

Arithmetic vs. Geometric

Mean
So which is better?
The arithmetic average is overly
optimistic for long horizons
The geometric average is overly
pessimistic for short horizons

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Arithmetic vs. Geometric

Mean
So which is better?
The answer depends on the planning period
under consideration:
15 20 years or less: use the arithmetic
20 40 years or so: split the difference
between them
40 + years: use the geometric
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Example: Computing
Averages
What is the arithmetic and geometric average
for the following returns?

Year 1 5%
Year 2 - 3%
Year 3 12%
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Arithmetic vs. Geometric

Mean
Arithmetic average return earned in an
average period over multiple periods

(5 + (-3) + 12) /3 = 4.67%

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Arithmetic vs. Geometric

Mean
Geometric average average compound return
per period over multiple periods

[(1 + .05)*(1-.03)*(1+.12)]1/3 -1
= .0449 = 4.49%

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Practice
What are the arithmetic and geometric average
returns for a stock with annual returns of 19 percent,
9 percent, 4 percent, and 13 percent? List the
arithmetic answer first.

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Now lets add risk to the

picture

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Variance and Standard

Deviation

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Variance and Standard

Deviation
Variance and standard deviation measure the
volatility of asset returns
The greater the volatility, the greater the
uncertainty
In finance, we use both variance and standard
deviation to measure

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Variance and Standard

Deviation
Historical variance =
sum of squared deviations from the
mean / (number of observations 1)
Standard deviation = square root of
the variance
Std. Dev. = Variance
http://performance.morningstar.com/fund/ratingsrisk.action?t=AEDCX&region=usa&culture=en-US
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Example Variance and

Standard Deviation
Year

Actual Averag
Return
e
Return

Deviation
from the
Mean

Squared
Deviation

.15

.105

.045

.002025

.09

.105

-.015

.000225

.06

.105

-.045

.002025

.12

.105

.015

.000225

Total
s

.42

.00

.0045

Variance = .0045 / (4-1) = .0015

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Standard Deviation = .03873

Practice
A stock had returns of 8 percent, 8 percent, 3
percent, and 14 percent over the past 4 years. What
is the standard deviation of this stock for the past
four years?

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Efficient Capital Markets

Are stocks correctly valued or priced?

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If the market is perfect, then it should be

efficient

An efficient market is where stock prices are in

equilibrium or are fairly priced

If this is true, then you should not be able to earn

abnormal or excess returns

Efficient markets DO NOT imply that investors

cannot earn a positive return in the stock market

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What Makes Markets

Efficient?
There are many investors out there doing research

As new information comes to market, this

information is analyzed and trades are made
based on this information
Therefore, prices should reflect all available
public information
If investors stop researching stocks, then the market
will not be efficient
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The Efficient Market

Hypothesis (EMH)
There are three forms of
the EMH:
1.Strong Form Efficiency
2.Semi-strong Form
Efficiency
3.Weak Form Efficiency
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Strong Form Efficiency

Prices reflect all information, including
public and private
If the market is strong form efficient, then
investors could not earn abnormal returns
regardless of the information they possessed
Empirical evidence indicates that markets
are NOT strong form efficient and that
insiders could earn abnormal returns
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Semi-strong Form
Efficiency

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Prices reflect all publicly available

information including trading information,
annual reports, press releases, etc.

If the market is semi-strong form efficient,

then investors cannot earn abnormal returns
by trading on public information

Implies that fundamental analysis will not

lead to abnormal returns

Weak Form Efficiency

Prices reflect all past market information such as
price and volume
If the market is weak form efficient, then investors
cannot earn abnormal returns by trading on market
information
Implies that technical analysis will not lead to
abnormal returns

Empirical evidence indicates that markets are

generally weak form efficient
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Common Misconceptions
about EMH
Efficient markets do not mean that you cant make
money
They do mean that, on average, you will earn a return
that is appropriate for the risk undertaken and there
is not a bias in prices that can be exploited to earn
excess returns

Market efficiency will not protect you from wrong

choices if you do not diversify you still dont want to
put all your eggs in one basket
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Comprehensive Problem
Your stock investments return 8%, 12%, and 4% in consecutive years.
1. What is the geometric return?
2. What is the sample standard deviation of the
above returns?

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3. Using the standard deviation and mean that

you just calculated, and assuming a normal
probability distribution, what is the
probability of losing 3% or more?

Comprehensive Problem
Your stock investments return 8%, 12%,
and -4% in consecutive years.
1. What is the geometric return?

(1.08 x 1.12 x .96)^ .333 -1 = .0511

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Comprehensive Problem
Your stock investments return 8%, 12%, and
-4% in consecutive years.
1. What is the geometric return?

2. What is the sample standard deviation of the

above returns?
Mean = (.08 + .12 + -.04) / 3 = .0533
Variance = (.08 - .0533)^2 + (.12 - .0533)^2
+ (-.04 - .0533)^2 / (3-1) = .00693
Standard deviation = .00693 ^ .5 = .0833
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Comprehensive Problem
Your stock investments return 8%, 12%, and 4% in consecutive years.
3. Using the standard deviation and mean that
you just calculated, and assuming a normal
probability distribution, what is the
probability of losing 3% or more?

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Probability: a 3% loss (return of -3%) lies one

standard deviation below the mean. There is 16%
of the probability falling below that point (68%
falls between -3% and 13.66%, so 16% lies below 3% and 16% lies above 13.66%).

Formulas
Total Dollar return = income + capital
gain (or loss)

Percentage return = dividend

yield + capital gain yield
Variance = sum of the squared
deviations from the mean / (number of
observations 1)
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Formulas
(continued)
Arithmetic average = sum of the return
earned over multiple years / number of
years
Geometric average = average
compound return per period
over multiple periods

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