RISK AND RETURN: LESSONS FROM
Answers to Concepts Review and Critical Thinking Questions
They all wish they had! Since they didn’t, it must have been the case that the stellar performance was
not foreseeable, at least not by most.
As in the previous question, it’s easy to see after the fact that the investment was terrible, but it
probably wasn’t so easy ahead of time.
No, stocks are riskier. Some investors are highly risk averse, and the extra possible return doesn’t
attract them relative to the extra risk.
Unlike gambling, the stock market is a positive sum game; everybody can win. Also, speculators
provide liquidity to markets and thus help to promote efficiency.
T-bill rates were highest in the early eighties. This was during a period of high inflation and is
consistent with the Fisher effect.
Before the fact, for most assets, the risk premium will be positive; investors demand compensation
over and above the risk-free return to invest their money in the risky asset. After the fact, the
observed risk premium can be negative if the asset’s nominal return is unexpectedly low, the risk-
free return is unexpectedly high, or if some combination of these two events occurs.
Yes, the stock prices are currently the same. Below is a diagram that depicts the stocks’ price
movements. Two years ago, each stock had the same price, P
. Over the first year, General
Materials’ stock price increased by 10 percent, or (1.1)
. Standard Fixtures’ stock price declined
by 10 percent, or (0.9)
. Over the second year, General Materials’ stock price decreased by 10
percent, or (0.9)(1.1)
, while Standard Fixtures’ stock price increased by 10 percent, or (1.1)(0.9)
. Today, each of the stocks is worth 99 percent of its original value.
2 years ago
1 year ago
The stock prices are not the same. The return quoted for each stock is the arithmetic return, not the
geometric return. The geometric return tells you the wealth increase from the beginning of the period
to the end of the period, assuming the asset had the same return each year. As such, it is a better
measure of ending wealth. To see this, assuming each stock had a beginning price of $100 per share,