distribution of outcomes (either historically or
projecting into the future) follows a
normal
(or, “bell
curve”) distribution
•
In reality, investment (such as stock) returns over
time may follow a skewed distribution – a distorted
version of the normal bell curve
–
In this class, though, we’ll stay with the
assumption of “normality”
FIN 300 - Risk and Return Pt. 1
29

Normal Distribution Graphs
•
Approximately 68% of the time, the return is expected
to be within +/- 1 standard deviation (
) of the mean
•
Roughly
speaking, 2/3 of the time you are within +/- 1
of the mean
–
1/3 of the time, you are in the tails (either at points
less than 1
below the mean – or greater than 1
above the mean)
•
As investors, we lose sleep over the bad outcomes (in
the “left tail”)
–
Due to the symmetry in the bell-curve, 1/6 of the time, we
expect to have a worse outcome than that 1
below the mean
FIN 300 - Risk and Return Pt. 1
30

Normal Distribution
FIN 300 - Risk and Return Pt. 1
31

Normal Distribution
•
Example: S&P 500 Stock Index
–
80+ year historical data
–
Mean annual return is roughly 10%
–
Annual returns have a standard deviation of
roughly 20%
–
Based on the long-term historical stats, the annual
return would be worse than -10% in 1 of every 6
years
•
1/6 of the time, expect to lose 10% of your investment!
•
This is not an unusual event – stocks are risky
FIN 300 - Risk and Return Pt. 1
32

Normal Distribution
FIN 300 - Risk and Return Pt. 1
33
S&P 500 Index: Mean = 10%
1/6 of the time
>
1/6 of the time
<
S&P 500 Index:

Historical Investment Data
•
Let’s look at some charts illustrating historical
returns for different asset classes
–
Examples of “asset classes”
•
Large-cap (large market value) stocks – S&P 500 Index
•
Small-cap stocks
•
Short-term U.S. Gov’t securities – such as T-Bills
•
Intermediate-term and longer-term U.S. gov’t securities
– T-Notes & T-Bonds
•
Corporate
bonds
FIN 300 - Risk and Return Pt. 1
34

History of Annual Returns for U.S. Stocks & Bonds
FIN 300 - Risk & Return
35

Cumulative Value of $1 Invested in 1926
Exhibit 7.5
FIN 300 - Risk & Return
36

Historical U.S.
Stock Returns
(1826! -2008)
Source:

Historical Risk & Return – Key Takeaways!
•
Based on long-term averages, we can generally
observe the following:
–
Stocks offer a higher return than bonds
•
Accordingly,
stocks have more risk than bonds
–
Small-cap (or, “small”) stocks offer a higher return
than large-cap (or, “large”) stocks
•
Accordingly,
small stocks are risker than large stocks
–
Long-term bonds offer a higher return than short-
term bonds
•
Accordingly, long-term bonds are risker than short-term
bonds
(we saw this, of course, in Chapter 8)
FIN 300 - Risk and Return Pt. 1
38

Choosing Among Investments
•
Given:
–
Stock A has a return of 20% and a standard
deviation (of returns) of 40%
–
Stock B has a return of 20% and a standard
deviation (of returns) of 45%
–
Stock C has a return of 25% and a standard
deviation (of returns) of 40%
•
Which one do I choose?

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- Fall '08
- Olander
- Finance, Standard Deviation, Corporate Finance, Return Pt.