some lessons from capital market history chapter 10
TRANSCRIPT
Some lessons from capital market history
Chapter 10
Key concepts and skills
Understand:– how to calculate the return on an
investment– the historical returns on various types of
investments– the historical risks of various types of
investments– the implications of market efficiency
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Chapter outline
• Returns• The historical record• Average returns: The first lesson• The variability of returns: The second
lesson• More on average returns• Capital market efficiency
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Risk, return and financial markets
• We can examine returns in the financial markets to help us determine the appropriate returns on non-financial assets.
• Lessons from capital market history:– There is a reward for bearing risk.– The greater the potential reward, the greater
the risk.– This is called the risk–return trade-off.
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Dollar returns
• Total dollar return = the return on an investment measured in dollars.• $ return = Dividends + Capital gains• Capital gains = Price received – Price paid
• Example:– You bought a bond for $950 one year ago. You have
received two coupons of $30 each. You can sell the bond for $975 today. What is your total dollar return?
• Income = 30 + 30 = $60• Capital gain = 975 – 950 = $25• Total dollar return = 60 + 25 = $85
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Percentage returns
• It is generally more intuitive to think in terms of percentages than dollar returns.
• Total percentage return = the return on an investment measured as a percentage of the original investment.– % return = $ return/$ invested
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Percentage returns (cont.)
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t
ttt
t
tt
t
t
P
PPD
CGYDY
P
PPCGY
P
DDY
11
1
1
Return%
Return%
- YieldGains Capital
YieldDividend
Calculating returnsExample 10.1
• You invest in a stock with a share price of $25. • After one year, the stock price per share is
$35. • Each share paid a $2 dividend.• What was your total return?
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Dollars PercentageDividend $2.00 $2/25 = 8%Capital gain $35 - $25 = $10 $10/25= 40 %Total return $2 + $10 = $12 $12/$25 = 48%
The historical record
A first look— Figure 10.4
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$1 invested in three major domestic classes as from the beginning of 1900
Quarter-by-quarter returns
• All Ordinaries Index—Figure 10.5
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Quarter-by-quarter returns (cont.)
• 10-year government bonds—Figure 10.6
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Quarter-by-quarter returns (cont.)
• Cash—Figure 10.7
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Quarter-by-quarter inflation
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Historical average returns
• Historical average return = simple, or arithmetic, average
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T
return yearly Return AverageHistorical
T
1i
Average returns: The first lesson1985–2009
Investment Average Return
All Ordinaries Index 13.3%
10-year government bonds 9.7%
Cash 8.%
Inflation 3.8%
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Risk premiums
• Risk-free rate– Rate of return on a riskless investment– Treasury bills are considered risk free
• Risk premium– Excess return on a risky asset over the
risk-free rate– Reward for bearing risk (the first lesson)
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Historical risk premiums
Investment Average return Risk premium
All Ordinaries Index 13.3% 3.3%
10-year government bonds
9.7% 1.7%
Cash 8.% 0.0
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Risk
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Risk is measured by the dispersion, spread or volatility of returns.
Figure 10.9—Frequencydistribution ofreturns on the AllOrdinaries Index,1985–2009
Return variability review
• Variance = VAR(R) or σ2
– Common measure of return dispersion – Also call variability
• Standard deviation = SD(R) or σ – Square root of the variance– Sometimes called volatility– Same ‘units’ as the average
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Return variability: The statistical tools for historical returns
• Return variance: (‘T’ = number of returns)
• Standard deviation:
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1T
RR σ VAR(R)
T
1i
2
i2
VAR(R) σ SD(R)
Example: Calculating historical variance
and standard deviation
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(1) (2) (3) (4) (5)
Average Difference: Squared:
Year Return Return: (2) - (3) (4) x (4)
1 0.10 0.04 0.06 0.0036
2 0.12 0.04 0.08 0.0064
3 0.03 0.04 -0.01 0.0001
4 -0.09 0.04 -0.13 0.0169
Sum: 0.16 Sum: 0.027
Average: 0.04 Variance: 0.009
0.0948683Standard Deviation:
Example: Work the Web• How volatile are mutual funds?• Standard deviations are widely reported for
mutual funds.• iShares MSCI Australia Index Fund is a mutual
fund, based in the United States, and set up to provide investors with results similar to an investment in the Australian share market.
• Click on the information icon, which takes you to <http://moneycentral.msn.com> for the quote of iShares MSCI Index.
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Historical average returns
and standard deviation
Figure 10.10
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Return variability review and concepts
• Normal distribution– A symmetric frequency distribution – The ‘bell-shaped curve’– Completely described by the mean and
variance
• Does a normal distribution describe asset returns?
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The normal distribution Figure 10.11
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Arithmetic vs geometric mean• Arithmetic average
– Return earned in an average period over multiple periods– Answers the question: ‘What was your return in an
average year over a particular period?’• Geometric average
– Average compound return per period over multiple periods– Answers the question: ‘What was your average compound
return per year over a particular period?’
• Geometric average < arithmetic average, unless all the returns are equal.
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Geometric average return: Formula
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1111 121 /T
N)R(...)R()R(GAR
Where:
Π = product (like Σ for sum)
Ri = return in each period
T = number of periods
Equation 10.4
1)1(/1
1
TT
iiRGAR
Calculating a geometric average return—Example 10.4
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Percent One Plus CompoundedYear Return Return Return:
Mar-93 8.42 1.0842 1.0842Jun-93 5.35 1.0535 1.1422Sep-93 13.72 1.1372 1.2989Dec-93 11.91 1.1191 1.4536Mar-94 -4.84 0.9516 1.3833Jun-94 -2.19 0.9781 1.3530Sep-94 2.72 1.0272 1.3898Dec-94 -4.48 0.9552 1.3275
1.0360
3.60%
(1.4870)^(1/8):
Geometric Average Return:
Arithmetic vs geometric meanWhich is better?
• The arithmetic average is overly optimistic for long horizons.
• The geometric average is overly pessimistic for short horizons.
• Depends on the planning period under consideration– 15–20 years or less: use arithmetic average– 20–40 years or thereabouts: split the difference
between them– 40 + years: use the geometric average
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Efficient capital markets
• The efficient market hypothesis– Stock prices are in equilibrium – Stocks are ‘fairly’ priced– Informational efficiency
• If true, you should not be able to earn ‘abnormal’ or ‘excess’ returns.
• Efficient markets DO NOT imply that investors cannot earn a positive return on the stock market.
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Reaction of stock price to new information in efficient and inefficient markets
Figure 10.12
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What makes markets efficient?
• There are many investors out there doing research.– As new information comes to market, this
information is analysed and trades are made based on this information.
– Therefore, prices should reflect all available public information.
• If investors stop researching share prices, the market will no longer be efficient.
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Common misconceptions about EMH
• EMH does not mean that you can’t make money.• EMH does mean that:
– on average, you will earn a return appropriate for the risk undertaken
– there is no bias in prices that can be exploited to earn excess returns
– market efficiency will not protect you from wrong choices if you do not diversify—you still don’t want to put all your eggs in one basket
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Forms of market efficiency
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Strong-form efficiency
• Prices reflect all information, including public and private.
• If the market were strong-form efficient, investors could not earn abnormal returns regardless of the information they possessed.
• Empirical evidence indicates that markets are NOT strong-form efficient and that insiders can earn abnormal returns.
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Semistrong-form efficiency
• Prices reflect all publicly available information, including trading information, annual reports and press releases.
• If the market is semistrong-form efficient, investors cannot earn abnormal returns by trading on public information.
• Implies that fundamental analysis will not lead to abnormal returns.
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Weak-form efficiency
• Prices reflect all past market information such as price and volume.
• If the market is weak-form efficient, investors cannot earn abnormal returns by trading on market information.
• Implies that technical analysis will not lead to abnormal returns.
• Empirical evidence indicates that markets are generally weak-form efficient.
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Quick quiz
• Which of the investments discussed have had the highest average return and risk premium?
• Which of the investments discussed have had the highest standard deviation?
• What is capital market efficiency?• What are the three forms of market
efficiency?
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Chapter 10
END
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