Capital Markets 1 Risk and Return: Historical Perspective Historical Returns Market Efficiency
Dec 26, 2015
Capital Markets 1
Risk and Return: Historical Perspective Historical Returns Market Efficiency
Capital Markets 2
Historical Returns 1926-2008
Average returns Arithmetic versus geometric
Risk premium = Return – risk-free return Compensation for taking risk
Standard deviation Measures variability of returns Two-thirds of the time returns should fall:
Capital Markets 3
Expected Return
Stock A Stock B
Probability Return Probability Return10% -15% -1.5% 20% -50% -10%
40% 10% 4% 30% 0% 0%
50% 25% 12.5% 50% 50% 25%
Expected Return 15% Expected Return 15%
Can Stock B have the same Expected
Return as Stock A???
Capital Markets 4
Historical Returns 1926-2008
Investment
Average
Return
Risk Premiu
mStandard Deviation
Large cap stocks 11.7% 7.9% 20.6%
Small cap stocks 16.4% 12.6% 33.0%
Long-term corporate bonds 5.9% 2.1% 8.4%
Treasury bills (Risk-free rate of return)
3.8% 0.0% 3.1%
Inflation 3.1% 4.2%
10/15/99 Wall Street Journal, equity risk premium has fallen from 10% in early 1980s to 2% in recent months…
Capital Markets 5
Unusual returns
S&P 500 Annual Return1995: 37.6% 1996: 23.0%1997: 33.4%1998: 28.6%1999: 21.9%
Capital Markets 6
Time In Market
One Year 25 Years
Return ReturnHigh 52.3% High 10.2%
Average 11.4% Average 8.9%
Low (2008…) -37.0% Low 7.9%
Capital Markets 7
Implications
Correlation of risk and rewardTo achieve above average returns, you
must take risk This can be done in an intelligent fashion!!!
Knowing your risk tolerance Time horizon: how long until I need this money? Diversification
Capital Markets 8
Time in Market
Investing for long-periods of time, likely you will have positive returns
Investing for long-period of time reduces risk. Time in market, not timing market is your
goal. In the short-run, anything can happen
Capital Markets 9
Reducing Risk While Obtaining Returns Diversify Invest for long-term
Capital Markets 10
Forms of market efficiency
Strong: all information is reflected in stock prices Including public and private information No one can outperform the market
What about Martha? Use of index funds
Diversification Efficiency
Underperformance by investors Average return large cap: Average return large cap mutual fund:
Expenses: management fees/trading costs
Average return large cap mutual fund investor:
Buying last period’s top performer
Capital Markets 11
Forms of market efficiency
Semi-strong: all publicly available information is reflected in stock prices Corporate financial analysis is a waste of time
Stock prices only react to “new” information differing from expectations
Questions: Assumes intelligent investors?
Valid assumption? Decline in inventory turnover ratio???
Assumes rational investors? Valid assumption?
Capital Markets 12
Forms of market efficiency
Weak: all prior stock price patterns reflected in stock pricesTechnical analysis is a waste of timeQuestion…
January effect…anomaly?? Sell losers, deduct losses up to $3,000 Hold winners, pay not tax until you sell