Chapter 10

RISK AND RETURN LESSONS FROM MARKET HISTORY

Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

10-1

KEY CONCEPTS AND SKILLS

Calculate the return on an investment
Compute the standard deviation of an investments
returns
Explain the connection between historical returns and
risks on various types of investments
Describe the importance of the normal distribution
and its relationship to investment return
Contextualize the US market risk premium in global
terms
Discern the impact on returns of the 2008 financial
crisis
Differentiate between arithmetic and geometric
average returns

10-2

CHAPTER OUTLINE
10.1
10.2
10.3
10.4
10.5
10.6
10.7
10.8

Returns
Holding Period Returns
Return Statistics
Average Stock Returns and Risk-Free
Returns
Risk Statistics
The U.S. Equity Risk Premium
2008: A Year of Financial Crisis
More on Average Returns
10-3

10.1 RETURNS
Returns have two components:
Current Income (e.g., interest or dividends);
and,
Capital Gains (or Losses)
Returns can be expressed in dollar or percentage
terms.

10-4

GRAPHIC REPRESENTATION OF
RETURNS
Dollar Returns:
the sum of the current
income received plus the
change in value of the
asset, in dollars.
Time

Initial
investment

Dividends
Ending
market value

1
Percentage Returns
the sum of the current income received
plus the change in value of the asset,
divided by the initial investment.
10-5

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FORMULAIC DEFINITION OF RETURNS

Dollar Return = Dividend + Change in Market Value

10-6

RETURNS: EXAMPLE
Suppose you bought 100 shares of WalMart (WMT) one year ago today at $50.
Over the last year, you received $100 in
dividends ($1 per share 100 shares). At
the end of the year, the stock sells for $60.
How did you do?
Quite well. You invested $50 100 =
$5,000. At the end of the year, you have
stock worth $6,000 and cash dividends of
$100. Your dollar gain was $1,100 = $100
+ ($6,000 $5,000).
Your percentage gain for the year is:
1,100/5,000 = 22%
10-7

RETURNS: EXAMPLE
Dollar Return:

$100

$1,100 gain

$6,000

Time

-$5,000

1
Percentage Return:

22% =

$1,100
$5,000
10-8

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10.2 HOLDING PERIOD RETURNS

The holding period return is the
return that an investor would get
when holding an investment over a
period of n years, when the return
during year i is given as ri.

10-9

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HOLDING PERIOD RETURN: EXAMPLE

Suppose your investment provides the
following returns over a four-year period:
Year Return
1
10%
2
-5%
3
20%
4
15%

10-10

HOLDING PERIOD RETURNS

A famous set of studies dealing with rates of
returns on common stocks, bonds, and
Treasury bills was conducted by Roger
Ibbotson and Rex Sinquefield.
They present year-by-year historical rates of
return starting in 1926 for the following five
important types of financial instruments in
the United States:

Large-company Common Stocks

Small-company Common Stocks
Long-term Corporate Bonds
Long-term U.S. Government Bonds
U.S. Treasury Bills

10-11

ILLUSTRATION: HOLDING PERIOD

RETURNS

10-12

UPS AND DOWNS: A FACT OF

INVESTING LIFE
Investments dont offer their returns on
a consistent basis:
Some years are higher;
Some years are lower: and,
Some years are losses

Historically:
The most rewarding investments have the most
volatile returns
The least rewarding investments have the least
volatile returns
10-13

RETURNS AND VOLATILITY: A

COMPARISON

Small Company Stocks

U.S. Treasury Bills

10-14

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10.3 RETURN STATISTICS

The history of capital market returns can

be summarized by describing the:
average return

Where R1RT are the individual observed returns

Where T is the time period analyzed

the frequency distribution of the returns

10-15

EXAMPLE FREQUENCY DISTRIBUTION

Frequency distribution is a histogram of yearly returns

10-16

INTERPRETATION OF THE EXAMPLE

FREQUENCY DISTRIBUTION
In the example above notice that:
Small company stocks have a higher average return
but a wider array (or variance) of actual returns
Large company stocks have a lower average return
but a more narrow array (or variance) of actual
returns.

Conclusion:
In any given observation period, it is more likely that
large company stocks will produce a return near the
mean than small company stocks.
On average, small company stocks produce a greater
return than large company stocks, but also present a
much greater likelihood of a loss in any given year
10-17

Historical Returns, 1926-2012

10-18

10.4 AVERAGE STOCK RETURNS AND

RISK-FREE RETURNS
U.S. government securities have very low
volatility, or risk
U.S. debt is considered risk free because the
government can raise taxes to repay it
Consider U.S. Treasury Bills, discount bonds
that mature in less than a year
The return of such a security is often
considered the risk-free rate.
The Risk Premium is the added return (over
and above the risk-free rate) resulting from
bearing risk.

10-19

RISK PREMIUM
Suppose that The Wall Street Journal announced
that the current rate for one-year Treasury bills
is 5%.
What is the expected return of small-company
stocks?
The average return on large company common
stocks for the period 1926 through 2012 was
11.8%.
Given a risk-free rate of 5%, and average large
company return of 11.8% the return premium
attributable solely to the risk of small company
stocks is 6.8%
10-20

THE RISK-RETURN TRADEOFF

The general rule:
The more volatile (or risky) a return is,
the greater the return will be expected
to be.

10-21

10.5 RISK STATISTICS

There is no universally agreed-upon definition
of risk.
The measures of risk that we discuss are
variance and standard deviation.
Variance and standard deviation measure the
dispersion of actual returns around the securitys
mean return
The standard deviation is the standard statistical
measure of the spread of a sample, and it is the
measure used in most cases.
Its interpretation is facilitated by a discussion of the
normal distribution.

10-22

NORMAL DISTRIBUTION
A large enough sample drawn from a normal distribution
looks like a bell-shaped curve.
Probability

The probability that a yearly return

will fall within 20.2 percent of the
mean of 11.8 percent will be
approximately 2/3.

3
48.8%

2
28.6%

1
8.4%

0
11.4%
68.26%

+ 1
32.0%

+ 2
52.2%

+ 3
72.4%

Return on large company

common stocks

95.44%
99.74%
10-23

NORMAL DISTRIBUTION
The return of large company stocks has a
standard deviation of 20.2 from 1926
through 2012.
That standard deviation can be interpreted
as follows:
if stock returns are approximately normally distributed,
the probability that a yearly return will fall within 20.2%
of the mean of 11.8% will be approximately 2/3.

10-24

EXAMPLE RETURN AND VARIANCE

Year

Actual
Return

Average
Return

Deviation from the

Mean

Squared
Deviation

.15

.105

.045

.002025

.09

.105

-.015

.000225

.06

.105

-.045

.002025

.12

.105

.015

.000225

.00

.0045

Totals

Variance = .0045 / (4-1) = .0015

Standard Deviation = .03873

10-25

10.6 THE U.S. EQUITY RISK PREMIUM

The past U.S. stock market risk premium has
been substantial
Did U.S. investors earn particularly large
returns?
Comparison to international markets is useful:
Greater than 50% of tradable stock is not in the US
17 have an average risk premium of 6.9%
US premium is 7.2%

U.S. Investors did well, but not dramatically

better than investors internationally
10-26

GLOBAL STOCK MARKET RISK

PREMIUMS

10-27

CONCLUSION: U.S. MARKET RISK

PREMIUM
Apparent global MRP mean is 6.9%
Given U.S. 7.2% mean MRP with a 19.8%
standard deviation, there is a 95% probability
that actual MRP is between 3.4 and 11%
226 financial economists independently
estimated MRP at 7%
Conclusion: U.S. MRP estimate of 7% is
reasonable barring unforeseen changes in risk
environment.
10-28

10.7 2008: A YEAR OF FINANCIAL

CRISIS
2008 was one of the worst years for stock
investors
S&P Index decreased 37%
Of 500 stocks in index, 485 were down for the year

The beginning of 2009 was also bad with a 25.1%

further S&P decline
From November 2007 through March 9, 2009 the
S&P lost 56.8% of its value
Things turned around dramatically in the
remainder of 2009, with the market gaining about
65%
10-29

2008 CRISIS: LESSONS LEARNED

Global Phenomenon No economy unscathed
Some securities performed well:
Treasury Bonds
High Quality Corporate Bonds
Flight to Quality Phenomenon

Reminder that stocks have significant risk and

can under- as well as over-perform the mean
Argues for careful diversification
Suggests that MRP may be greater than 7% right
now
10-30

10.8 MORE ON AVERAGE RETURNS:

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.
10-31

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GEOMETRIC RETURN: EXAMPLE

Year Return
1
10%
2
-5%
3
20%
4
15%

So, our investor made an average of 9.58% per year,

realizing a holding period return of 44.21%.

10-32

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GEOMETRIC RETURN: EXAMPLE

Note that the geometric average is not the

same as the arithmetic average:
Year Return
1
10%
2
-5%
3
20%
4
15%

10-33

FORECASTING RETURN
To address the time relation in forecasting
returns, use Blumes formula:

T 1
R (T )
GeometricAverage
N 1
N T

ArithmeticAverage
N 1
where, T is the forecast horizon and N is the number of
years of historical data we are working with. T must be
less than N.
10-34

QUICK QUIZ
Which of the investments discussed has had the
highest average return and risk premium?
Which of the investments discussed has had the
highest standard deviation?
Why is the normal distribution informative?
What is the difference between arithmetic and
geometric averages?

10-35