12
Some Chapter Lessons from
Capital Market History
McGraw-Hill/Irwin
Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Key Concepts and Skills
Know how to calculate the return on
an investment
Understand the historical returns on
various types of investments
Understand the historical risks on
various types of investments
Understand the implications of
market efficiency
12-2
Chapter Outline
Returns
The Historical Record
Average Returns: The First Lesson
The Variability of Returns: The
Second Lesson
More about Average Returns
Capital Market Efficiency
12-3
Risk, Return and Financial
Markets
We can examine returns in the financial
markets to help us determine the
appropriate returns on non-financial assets
Lessons from capital market history
There is a reward for bearing risk
The greater the potential reward, the greater the
risk
This is called the risk-return trade-off
12-4
Dollar Returns
Total dollar return = income from investment
+ capital gain (loss) due to change in price
Example:
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?
Income = 30 + 30 = 60
Capital gain = 975 950 = 25
Total dollar return = 60 + 25 = $85
12-5
Percentage Returns
It is generally more intuitive to think in terms
of percentage, rather than dollar, returns
Dividend yield = income / beginning price
Capital gains yield = (ending price
beginning price) / beginning price
Total percentage return = dividend yield +
capital gains yield
12-6
Example Calculating
Returns
You bought a stock for $35, and you
received dividends of $1.25. The
stock is now selling for $40.
What is your dollar return?
Dollar return = 1.25 + (40 35) = $6.25
What is your percentage return?
Dividend yield = 1.25 / 35 = 3.57%
Capital gains yield = (40 35) / 35 =
14.29%
Total percentage return = 3.57 + 14.29 =
17.86%
12-7
The Importance of Financial
Markets
Financial markets allow companies,
governments and individuals to increase their
utility
Savers have the ability to invest in financial assets
so that they can defer consumption and earn a
return to compensate them for doing so
Borrowers have better access to the capital that is
available so that they can invest in productive assets
Financial markets also provide us with
information about the returns that are required
for various levels of risk
12-8
Figure 12.4
Insert Figure 12.4 here
12-9
Year-to-Year Total Returns
Large-Company Stock Returns
LargeCompanies
Long-Term Government
Bond Returns
U.S. Treasury Bill Returns
LongTermGovernmentBonds
U.S.TreasuryBills
12-10
Average Returns
Investment
Average Return
Large Stocks
12.3%
Small Stocks
17.1%
Long-term Corporate
Bonds
6.2%
Long-term Government
Bonds
5.8%
U.S. Treasury Bills
3.8%
Inflation
3.1%
12-11
Risk Premiums
The extra return earned for taking
on risk
Treasury bills are considered to be
risk-free
The risk premium is the return over
and above the risk-free rate
12-12
Table 12.3 Average Annual
Returns and Risk Premiums
Investment
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 Government
Bonds
5.8%
2.0%
U.S. Treasury Bills
3.8%
0.0%
12-13
Figure 12.9
Insert Figure 12.9 here
12-14
Variance and Standard
Deviation
Variance and standard deviation measure
the volatility of asset returns
The greater the volatility, the greater the
uncertainty
Historical variance = sum of squared
deviations from the mean / (number of
observations 1)
Standard deviation = square root of the
variance
12-15
Example Variance and
Standard Deviation
Year
Actual
Return
Average
Return
Deviation from
the Mean
Squared
Deviation
1
.15
.105
.045
.002025
2
.09
.105
-.015
.000225
3
.06
.105
-.045
.002025
4
.12
.105
.015
.000225
Totals
.42
.00
.0045
Variance = .0045 / (4-1) = .0015
Standard Deviation = .03873
12-16
Work the Web Example
How volatile are mutual funds?
Morningstar provides information on
mutual funds, including volatility
Click on the web surfer to go to the
Morningstar site
Pick a fund, such as the AIM European
Development fund (AEDCX)
Enter the ticker, press go and then Risk
Measures
12-17
Figure click 12.10
Insert Figure 12.10 here
12-18
Figure 12.11
Insert figure 12.11 here
12-19
Arithmetic vs. Geometric
Mean
Arithmetic average return earned in an average
period over multiple periods
Geometric average average compound return per
period over multiple periods
The geometric average will be less than the arithmetic
average unless all the returns are equal
Which is better?
The arithmetic average is overly optimistic for long horizons
The geometric average is overly pessimistic for short horizons
So, 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
12-20
Example: Computing
Averages
What is the arithmetic and geometric
average for the following returns?
Year 1
5%
Year 2
-3%
Year 3
12%
Arithmetic average = (5 + (3) + 12)/3 = 4.67%
Geometric average =
[(1+.05)*(1-.03)*(1+.12)]1/3 1 = .0449 = 4.49%
12-21
Efficient Capital Markets
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
12-22
Figure 12.13
Insert figure 12.13 here
12-23
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
12-24
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
12-25
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
12-26
Semistrong Form Efficiency
Prices reflect all publicly available
information including trading information,
annual reports, press releases, etc.
If the market is semistrong form efficient,
then investors cannot earn abnormal
returns by trading on public information
Implies that fundamental analysis will not
lead to abnormal returns
12-27
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
12-28
Quick Quiz
Which of the investments discussed have
had the highest average return and risk
premium?
Which of the investments discussed have
had the highest standard deviation?
What is capital market efficiency?
What are the three forms of market
efficiency?
12-29
Ethics Issues
Program trading is defined as automated trading
generated by computer algorithms designed to
react rapidly to changes in market prices. Is it
ethical for investment banking houses to operate
such systems when they may generate trade
activity ahead of their brokerage customers, to
which they owe a fiduciary duty?
Suppose that you are an employee of a printing firm
that was hired to proofread proxies that contained
unannounced tender offers (and unnamed targets).
Should you trade on this information, and would it
be considered illegal?
12-30
Comprehensive Problem
Your stock investments return 8%, 12%,
and -4% in consecutive years. What is the
geometric return?
What is the sample standard deviation of
the above returns?
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?
12-31