12 - Some Lessons From Capital Market History Chapter...

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Unformatted text preview: Some Lessons From Capital Market History Chapter Twelve Chapter Outline • Returns • The Historical Record • Average Returns: The First Lesson • The Variability of Returns: The Second Lesson • Capital Market Efficiency Risk, Return and Financial Markets • We can examine returns in the financial markets to help us determine the appropriate returns on non-financial assets • Lesson 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 Returns and Prices • We observe prices in markets and then calculate returns • Big Issue: Are those prices meaningful? What information is reflected in prices? return = t t P P CF P P- + 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 arithmetic • 20 – 40 years or so: split the difference between them • 40 + years: use the geometric Example: Computing Averages...
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12 - Some Lessons From Capital Market History Chapter...

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