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Unformatted text preview: Lecture 10: Risk and Return Theories I I : Why do some financial assets have historically higher returns than others? Over the past 10 years, Microsoft has enjoyed a higher return GM Differences like Microsoft/GM are not the result of picking winners and comparing them to losers with the benefit of hindsight. Even large well-diversified indexes exhibit differences in return that are too large and persistent to be the result of lucky runs. Over the past 50 years, stocks have consistently outperformed bonds and certain stock indexes such as the NASDAQ have outperformed other stock indexes (S&P 500, DJIA) How do we explain persistent differences in return? Why do investors hold stocks with low expected returns? The answer is risk. II. Risk and Return Let r n denote the net return on asset n. (n = 1,2) Let σ n denote the standard deviation of asset n. If investors are risk-averse we say asset 1 stochastically dominates asset 2 if: E[r 1 ] > E[r 2 ] and σ 1 < σ 2 with at least one inequality If a risk-averse investor were forced to invest in only one asset, she would not choose a stochastically dominated asset....
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- Winter '08
- Variance, EFFICIENT FRONTIER