Chapter 7

An Introduction to Risk and Return: History of Financial Market Returns

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Slide Contents
Learning Objectives Principles Used in This Chapter
1. 2. 3. Calculate Realized and Expected Rates of Return and Risk. Describe the Historical Pattern of Financial Market Returns. Compute Geometric and Arithmetic Average Rates of Return.

Slide Contents (cont.)

4. Explain Efficient Market Hypothesis and Why it is Important to Stock Prices. Key Terms

7.1 Realized and Expected Rates of Return and Risk

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Calculating the Realized Return from an Investment

Realized return or cash return measures the gain or loss on an investment.

Calculating the Realized Return from an Investment (cont.)

Example 1: You invested in 1 share of Apple (AAPL) for $95 and sold a year later for $200. The company did not pay any dividend during that period. What will be the cash return on this investment?

Calculating the Realized Return from an Investment (cont.)

Cash Return = $200 + 0 - $95 = $105

Calculating the Realized Return from an Investment (cont.)

We can also calculate the rate of return as a percentage. It is simply the cash return divided by the beginning stock price.

Calculating the Realized Return from an Investment (cont.)

Example 2: You invested in 1 share of share Apple (AAPL) for $95 and sold a year later for $200. The company did not pay any dividend during that period. What will be the rate of return on this investment?

Calculating the Realized Return from an Investment (cont.)

Rate of Return = ($200 + 0 - $95) 95 = 110.53%

Table 7-1 has additional examples on measuring an investors realized rate of return from investing in common stock.

Calculating the Realized Return from an Investment (cont.)

Table 7-1 indicates that the returns from investing in common stocks can be positive or negative. Furthermore, past performance is not an indicator of future performance. However, in general, we expect to receive higher returns for assuming more risk.

Calculating the Expected Return from an Investment

Expected return is what you expect to earn from an investment in the future. It is estimated as the average of the possible returns, where each possible return is weighted by the probability that it occurs.

Calculating the Expected Return from an Investment (cont.)

Calculating the Expected Return from an Investment (cont.)

Expected Return = (-10%0.2) + (12%0.3) + (22%0.5) = 12.6%

Measuring Risk
In the example on Table 7-2, the expected return is 12.6%; however, the return could range from -10% to +22%. This variability in returns can be quantified by computing the Variance or Standard Deviation in investment returns.

Measuring Risk (cont.)

Standard deviation is given by square root of the variance and is more commonly used.

Calculating the Variance and Standard Deviation of the Rate of Return on an Investment

Let us compare two possible investment alternatives:

(1) U.S. Treasury Bill Treasury bill is a short-term debt obligation of the U.S. Government. Assume this particular Treasury bill matures in one year and promises to pay an annual return of 5%. U.S. Treasury bill is considered risk-free as there is no risk of default on the promised payments.

Calculating the Variance and Standard Deviation of the Rate of Return on an Investment (cont.)

(2) Common stock of the Ace Publishing Company an investment in common stock will be a risky investment.

Calculating the Variance and Standard Deviation of the Rate of Return on an Investment (cont.)

The probability distribution of an investments return contains all possible rates of return from the investment along with the associated probabilities for each outcome. Figure 7-1 contains a probability distribution for U.S. Treasury bill and Ace Publishing Company common stock.

Calculating the Variance and Standard Deviation of the Rate of Return on an Investment (cont.)

The probability distribution for Treasury bill is a single spike at 5% rate of return indicating that there is 100% probability that you will earn 5% rate of return. The probability distribution for Ace Publishing company stock includes returns ranging from 10% to 40% suggesting the stock is a risky investment.

Calculating the Variance and Standard Deviation of the Rate of Return on an Investment (cont.)

Using equation 7-3, we can calculate the expected return on the stock to be 15% while the expected return on Treasury bill is always 5%. Does the higher return of stock make it a better investment? Not necessarily, we also need to know the risk in both the investments.

Calculating the Variance and Standard Deviation of the Rate of Return on an Investment (cont.)

We can measure the risk of an investment by computing the variance as follows:

Calculating the Variance and Standard Deviation of the Rate of Return on an Investment (cont.)
Investment Treasury Bill Common Stock Expected Return 5% 15% Standard Deviation 0% 12.85%

So we observe that the publishing company stock offers a higher expected return but also entails more risk as measured by standard deviation. An investors choice of a specific investment will be determined by their attitude toward risk.

Checkpoint 7.1
Evaluating an Investments Return and Risk
Clarion Investment Advisors is evaluating the distribution of returns for a new stock investment and has come up with five possible rates of return for the coming year. Their associated probabilities are as follows:

a. What expected rate of return might they expect to realize from the investment? b. What is the risk of the investment as measured using the standard deviation of possible future rates of return?

Checkpoint 7.1

Checkpoint 7.1

Checkpoint 7.1

Checkpoint 7.1: Check Yourself

Compute the expected return and standard deviation for an investment with the five following possible probabilities for the coming year: .2, .2,.3,.2 and .1and rates of return are 20%,0%,15%,30% and 50% Respectively.

7.2 A Brief History of the Financial Markets

Copyright 2011 Pearson Prentice Hall. All rights reserved.

A Brief History of the Financial Markets

We can use the tools that we have learned to determine the risk-return tradeoff in the financial markets.

A Brief History of the Financial Markets (cont.)

Investors have historically earned higher rates of return on riskier investments. However, having a higher expected rate of return simply means that investors expect to realize a higher return. Higher return is not guaranteed.

U.S. Financial Markets Domestic Investment Returns

Figure 7-2 shows the historical returns earned on four types of investments (small stocks, large stocks, government bonds, treasury bills) over the period 1926-2008. The graph shows the value of $1 investment made in each of these asset categories in 1926 and held until the end of 2008.

U.S. Financial Markets Domestic Investment Returns (cont.)

U.S. Financial Markets Domestic Investment Returns (cont.)

We observe a clear relationship between risk and return. Small stocks have the highest annual return but higher returns are associated with much greater risk.
Annual Small Stocks Large Stocks
Governme nt Bonds

Treasur y Bills

Return S.D.

11.7% 34.1%

9.6% 21.4%

5.7% 8.5%

3.7% 0.9%

Lessons Learned from Historical Returns in the Financial Market

Lesson #1: The riskier investments have historically realized higher returns.
The difference between the return on riskier stock investments and government securities is called the equity risk premium. For example, the equity risk premium is 6% for small stocks over government bonds.

Lessons Learned from Historical Returns in the Financial Market (cont.)

Lesson #2: The historical returns of the higher-risk investment classes have higher standard deviations. For example, small stocks had a standard deviation of 34.1% while the standard deviation of treasury bill was only 0.9%.

U.S. Stocks versus Other Categories of Investments

Figure 7-3 illustrates the growth in the value of $1 invested in 1980 until the end of 2010 for five different asset classes:
U.S. stocks Real estate International stocks Commodities Gold

U.S. Stocks versus Other Categories of Investments (cont.)

We can observe from Figure 7-3 that Real Estate had the highest annual return of 11.8% while gold had the lowest return of 2.5%.

Global Financial Markets International Investing

Figure 7-4 compares the historical returns from investing in U.S. stocks and bonds to returns on international stocks and bonds. The fluctuation in rates of return over a period of time is called the investments volatility, which is measured by standard deviation.

Global Financial Markets International Investing (cont.)

Global Financial Markets International Investing (cont.)

We observe that Pacific stocks had the highest volatility with returns ranging from a high of 107.5% to a low of -36.2%. In contrast, the US stocks had the least volatility with returns ranging from a high of 37.6% and a low of -37.0%.

Global Financial Markets International Investing (cont.)

Figure 7-5 compares the average rate of return earned from investing in developed countries, such as the US and Europe and some parts of Asia, to the returns from investing in equities of companies located in emerging markets.

Global Financial Markets International Investing (cont.)

An emerging market is one located in country with low-to-middle per capita income (such as China, India). These countries represent about 80% of the worlds population and about 20% of the worlds economies. A developed country is sometimes referred to as an industrialized country that have highly sophisticated and well developed economies.

Global Financial Markets International Investing (cont.)

We observe from figure 7-5 that the average rates of return from investing in emerging markets were generally higher than those earned in developed countries group. However, emerging market also had much more volatile returns over the period 19882008.

7.3 Geometric vs. Arithmetic Average Rates of Return

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Geometric vs. Arithmetic Average Rates of Return

Arithmetic average may not always capture the true rate of return realized on an investment. In some cases, geometric or compound average may be a more appropriate measure of return.

Geometric vs. Arithmetic Average Rates of Return (cont.)

For example, suppose you bought a stock for $25. After one year, the stock rises to $30 and in the second year, it falls to $15. What was the average return on this investment?

Geometric vs. Arithmetic Average Rates of Return (cont.)

The stock earned +20% in the first year and 50% in the second year. Simple average = (20%-50%) 2 = -15%

Geometric vs. Arithmetic Average Rates of Return (cont.)

However, over the 2 years, the $25 stock lost the equivalent of 22.54% ({($15/$25)1/2} - 1 = 22.54%). Here, -15% is the simple arithmetic average while -22.54% is the geometric or compound average rate. Which one is the correct indicator of return? It depends on the question being asked.

Geometric vs. Arithmetic Average Rates of Return (cont.)

The geometric average rate of return answers the question, What was the growth rate of your investment? The arithmetic average rate of return answers the question, what was the average of the yearly rates of return?

Computing Geometric Average Rate of Return

Computing Geometric Average Rate of Return (cont.)

Compute the arithmetic and geometric average for the following stock.
Year
0 1 2 40% -50%

Annual Rate of Return

Value of the stock

$25 $35 $17.50

Computing Geometric Average Rate of Return (cont.)

Arithmetic Average = (40-50) 2 = -5% Geometric Average
= [(1+Ryear1) (1+Ryear 2)]1/2 - 1 = [(1.4) (.5)] 1/2 - 1 = -16.33%

Choosing the Right Average

Both arithmetic average geometric average are important and correct. The following grid provides some guidance as to which average is appropriate and when:

Question being addressed:

Appropriate Average Calculation:

What annual rate of The arithmetic average return can we expect for calculated using annual next year? rates of return.

What annual rate of return can we expect over a multi-year horizon?

The geometric average calculated over a similar past period.

Checkpoint 7.2
Computing the Arithmetic and Geometric Average Rates of Return Five years ago Marys grandmother gave her $10,000 worth of stock in the shares of a publicly traded company founded by Marys grandfather. Mary is now considering whether she should continue to hold the shares, or perhaps sell some of them. Her first step in analyzing the investment is to evaluate the rate of return she has earned over the past five years. The following table contains the beginning value of Marys stock five years ago as well as the values at the end of each year up until today (the end of year 5):

What rate of return did Mary earn on her investment in the stock given to her by her grandmother?

Checkpoint 7.2

Checkpoint 7.2

Checkpoint 7.2

Checkpoint 7.2: Check Yourself

Mary has decided to keep the stock given to her by her grandmother. However, now she wants to consider the prospect of selling another gift made to her five years ago by her grandmother. What are the arithmetic and geometric average rates of return for the following investment? See table on the next slide.

Problem (cont.)

Year

Annual Rate of Return

Value of the Stock

0 1 2
3 4 5

$10,000.00 -15.0% 15.0%

25.0% 30.0% -10.0%

$8,500.00 $9,775.00
$12,218.75 $15,884.38 $14,295.94

Step 1: Picture the Problem

Value of Stock
$18,000.00

$16,000.00
$14,000.00 $12,000.00 $10,000.00 $8,000.00 $6,000.00 $4,000.00 $2,000.00

$0.00
0 1 2 3 Year 4 5 6

Step 2: Decide on a Solution Strategy

We need to calculate the arithmetic and geometric average. The arithmetic average fails to capture the effect of compound interest, which can be measured by geometric average.

Step 3: Solve
Calculate the Arithmetic Average Arithmetic Average
= Sum of the annual rates of return Number of years = 45% 5 = 9%

Based on past performance of the stock, Mary should expect that it would earn 9% next year.

Step 3: Solve (cont.)

Calculate the Geometric Average Geometric Average = [(1+Ryear1) (1+Ryear 2 ) (1+Ryear3) (1+Ryear4) (1+Ryear5) ]1/5 - 1 = [(.85) (1.15) (1.25) (1.30) (.90)] 1/5 - 1
= 7.41%

Step 4: Analyze
The arithmetic average is 9% while the geometric average is 7.41%. The geometric average is lower as it incorporates compounding of interest. Both of these averages are useful and meaningful but in answering two very different questions.

Step 4: Analyze (cont.)

The arithmetic average answers the question, what rate of return Mary can expect from her investment next year assuming all else remains the same as in the past? The geometric average answers the question, what rate of return Mary can expect over a five-year period?

7.4 What Determines Stock Prices?

Copyright 2011 Pearson Prentice Hall. All rights reserved.

What Determines Stock Prices?

In short, stock prices tend to go up when there is good news about future profits, and they go down when there is bad news about future profits. Since US businesses have generally done well over the past 80 years, the stock returns have also been favorable.

The Efficient Market Hypothesis

The efficient market hypothesis (EMH) states that securities prices accurately reflect future expected cash flows and are based on information available to investors. An efficient market is a market in which all the available information is fully incorporated into the prices of the securities and the returns the investors earn on their investments cannot be predicted.

The Efficient Market Hypothesis (cont.)

We can distinguish among three types of efficient market, depending on the degree of efficiency:
1. The Weak-Form Efficient Market Hypothesis 2. The Semi-Strong Form Efficient Market Hypothesis 3. The Strong Form Efficient Market Hypothesis

The Efficient Market Hypothesis (cont.)

(1) The Weak-Form Efficient Market Hypothesis asserts that all past security market information is fully reflected in security prices. This means that all price and volume information is already reflected in a securitys price.

The Efficient Market Hypothesis (cont.)

(2) The Semi-Strong-Form Efficient Market Hypothesis asserts that all publicly available information is fully reflected in security prices. This is a stronger statement as it includes all public information (such as firms financial statements, analysts estimates, announcements about the economy, industry, or company.)

The Efficient Market Hypothesis (cont.)

(3) The Strong-Form Efficient Market Hypothesis asserts that all information, regardless of whether this information is public or private, is fully reflected in securities prices. It asserts that there isnt any information that isnt already embedded into the prices of all securities.

Do We Expect Financial Markets To Be Perfectly Efficient?

In general, markets are expected to be at least weak form and semi-strong form efficient. If there did exist simple profitable strategies, then the strategies would attract the attention of investors, who by implementing their strategies would compete away the profits.

Do We Expect Financial Markets To Be Perfectly Efficient? (cont.)

We would not expect financial markets to be strong-form efficient. We expect the markets to partially, but not perfectly, reflect information that is privately collected. The markets will be inefficient enough to provide some investors with an opportunity to recoup their costs of obtaining information, but not so inefficient that there is easy money to be made in the stock market.

The Behavioral View

Efficient market hypothesis is based on the assumption that investors, as a group, are pretty rational. This view has been challenged. What if investors are not rational?

The Behavioral View (cont.)

If investors do not rationally process information, then markets may not accurately reflect even public information.

The Behavioral View (cont.)

For example, overconfident investors may under react when management announces earnings as they have too much confidence in their own views of the companys true value and tend to place too little weight on new information provided by management. As a result, this new information, even though it is publicly and freely available, is not completely reflected in stock prices.

Market Efficiency What does the Evidence Show?

The degree of efficiency of financial markets is an important question and has generated extensive research. Historically, there has been some evidence of inefficiencies in the financial markets. This is summarized by three observations in Table 74.