Chap 10_Portfolio Theory and the Capital Asset Pricing Model

# Chap 10_Portfolio Theory and the Capital Asset Pricing...

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M G M T 50 5, Fal l 20 RWJ, Chapters 10,11 Click to edit Master subtitle style Risk and Expected Returns

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M G M T 50 5, Fal l 20 RWJ, Chapters 10,11 Computing Returns Holding period Return on a stock = Returns from Capital Gains + Return on Dividends = (Sale price–Acquisition price+Dividends) / Acq.price* If R1, R2, … Rn represent the annual return on the stock, then the holding period return equals If Rh is the n-year holding period return, then the annualized average return over the holding period, r, can be computed from the formula * assuming that dividends are paid just before the end of the holding period
M G M T 50 5, Fal l 20 RWJ, Chapters 10,11 Geometric vs. Arithmetic Averages Suppose the Dow gains 10% next year and drops 10% the following year. If you invested in the Dow today, what will be your 2-year holding period return? If we simply average the returns, the answer is zero. If Dow is 10,000 today, then 10% gain =1000 points. Thus Dow will be at 11,000 next year. A drop of 10% from there is 1100 points, to 9,900. Your holding period return will be negative 1%. (1+0.10)*(1-0.10)-1= -0.01 or (9900-10000)/10000 The average annualized return will be (1-0.01)1/2 –1 = -0.501%

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M G M T 50 5, Fal l 20 RWJ, Chapters 10,11 Historical Returns, 1926-2004 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. – 90% + 90% 0% Average Standard Series Annual Return Deviation Distribution Large Company Stocks 12.3% 20.2% Small Company Stocks 17.4 32.9 Long-Term Corporate Bonds 6.2 8.5 Long-Term Government Bonds 5.8 9.2 U.S. Treasury Bills 3.8 3.1 Inflation 3.1 4.3 Updated figure from Ibbotson
M G M T 50 5, Fal l 20 RWJ, Chapters 10,11 Stocks, Bonds, Bills, and Inflation Chart Year end 1925–2006. Hypothetical value of \$1 invested at year-end 1925. Assumes reinvestment of income and no transaction costs or taxes.

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M G M T 50 5, Fal l 20 RWJ, Chapters 10,11 Rates of Return 1926-2002 0 2 4 6 8 10 12 Source: © Stocks, Bonds, Bills, and Inflation 2000 Yearbook™ , Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.
M G M T 50 5, Fal l 20 RWJ, Chapters 10,11 Risk Vs. Returns What can we infer from previous slide? Riskier (higher standard deviation) investments have historically yielded higher average returns. Some researchers believe that stocks have historically earned more, adjusted for risk. The difference between the average return on stocks vs. bonds is called the equity risk premium. Historical returns on stocks may have been too high adjusting for their risk. Increase or Decrease in late 2008? How about now?

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Chap 10_Portfolio Theory and the Capital Asset Pricing...

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