MIT15 401F08 Lec12

15.
401
15.401 Finance Theory

MIT Sloan MBA Program
Andrew W. Lo
Harris & Harris Group Professor, MIT Sloan School
Lecture 12: Introduction to Risk and Return
© 2007–2008 by Andrew W. Lo
Critical Concepts 15.401
Motivation
Statistical Background
Empirical Properties of Stock Returns
Anomalies
Readings
Brealey, Myers, and Allen Chapters 7, 24.1, 24.4
© 2007–2008 by Andrew W. Lo Slide 2

Lecture 12: Intro to Risk and Return
Motivation 15.401
NPV and Other Valuation Techniques Need Cost of Capital

Opportunity cost
Required rate of return
Risk-adjusted discount rate
Determined by “the market”
How???
Introduce Risk Into The Valuation Process

How to measure risk
How to estimate the required rate of return for a given level of risk
Related questions:
– How risky are stocks and what have their returns been historically?
– Is the stock market “efficient”?
– How can we gauge the performance of portfolio managers?

Statistical Background 15.401
Terminology

Terminology
Mean, variance, standard deviation:
Sample estimators:

Other Statistics
Median
– 50th percentile (probability of 1/2 that Rt < median)
Skewness
– Is the distribution symmetric?
– Negative: big losses are more likely than big gains
– Positive: big gains are more likely than big losses
Correlation
– How closely do two variables move together?

Negatively Skewed Distribution
-5 -4 -3 -2 -1 0 1 2 3 4 5

Examples of Correlation Between Two Random Variables

4 3
ρ=0 3
ρ = .5 2
2
1
1
0
0 -4 -3 -2 -1 0 1 2 3 4
-4 -3 -2 -1 0 1 2 3 4 -1
-1
-2
-2
-3 -3
-4 -4
4 3
ρ = .8 3
ρ = –.5 2
2
1
1
0
0 -4 -3 -2 -1 0 1 2 3 4
-4 -3 -2 -1 0 1 2 3 4 -1
-1
-2
-2
-3 -3
-4 -4

Normal Distribution
Bell-shaped, symmetric
A model of randomness
Central Limit Theorem
Confidence Intervals
-5 -4 -3 -2 -1 0 1 2 3 4 5
If R is normally distributed, then …
68% of observations fall within +/–1.00 std. deviations from mean

GM Monthly Returns
0.21
0.14
0.07
0.00
-21% -15% -9% -3% 3% 9% 15% 21%

Empirical Properties of Stock Returns 15.401
What Characterizes U.S. Stock Returns?

How volatile are stock returns?
Are returns predictable?
How does volatility change over time?
What types of stocks have the highest returns?
What Properties Should Stock Prices Have In “Efficient” Markets?

Random, unpredictable
Prices should react quickly and correctly to news
Investors cannot earn abnormal, risk-adjusted returns (or at least it
shouldn’t be easy)

Predictable Price Changes

$ 80
70
60
50
40
30
20

Random Walks with Drift

$ 80
75
70
65
60
55
50
0 10 20 30 40 50 60 70 80 90 100

Four facts from history of U.S. financial markets:

1. Real interest rate has been slightly positive on average.
2. Return on more risky assets has been higher on average than return
on less risky assets.
3. Returns on risky assets can be highly correlated to each other.
4. Returns on risky assets are (usually) serially uncorrelated.
Basic Statistics, U.S., 1946 – 2001 (monthly,in percent)

Avg Stdev Skew Min Max
Inflation 0.32 0.36 0.82 -0.84 1.85
Tbill (1 yr) 0.38 0.24 0.98 0.03 1.34
Tnote (10 yr) 0.46 2.63 0.61 -7.73 13.31
VW stock index 1.01 4.23 -0.47 -22.49 16.56
EW stock index 1.18 5.30 -0.17 -27.09 29.92
Motorola 1.66 10.02 0.01 -33.49 41.67
NYSE, Amex, NASDAQ: 6,700 firms, $16.4 trillion market cap

Total Return of Stocks, Bonds, Bills and Inflation 1946 – 2001

10000
cpi tbill 10 note vw ew
1000
100
10
0.1
Dec-45 Dec-53 Dec-61 Dec-69 Dec-77 Dec-85 Dec-93 Dec-01

Interest Rates 1953 – 2001

18%
1-yr Tbill 10-yr Tbond
15%
12%
9%
6%
3%
0%
Jun-53 Jan-63 Jun-72 Jan-82 Jun-91 Jan-01

Total Returns, 10-Year U.S. T-Bond, 1946 – 2001

25%
20%
15%
10%
5%
0%
-5%
-10%
-15%
-20%
-25%
Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan-
46 51 56 61 66 71 76 81 86 91 96 01

Total Returns, U.S. Stock Market 1946 – 2001

25%
20%
15%
10%
5%
0%
-5%
-10%
-15%
-20%
-25%
Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan-
46 51 56 61 66 71 76 81 86 91 96 01

Total Returns, Motorola 1946 – 2001

25%
20%
15%
10%
5%
0%
-5%
-10%
-15%
-20%
-25%

Scatterplot, VWRETD Today vs. Yesterday ,1980 – 1999

2.0%
1.0%
0.0%
-2.5% -1.5% -0.5% 0.5% 1.5% 2.5%
-1.0%
-2.0%

Scatterplot, S&P 500 This Month vs. Last Month, 1926 to 1997
20%
15%
10%
5%
0%
-25% -15% -5% 5% 15% 25%
-5%
-10%
-15%
-20%

Scatterplot GM vs. S&P 500 Monthly Returns, 1946 – 1997

25%
17%
8%
0%
-35% -25% -15% -5% 5% 15% 25% 35%
-8%
-17%
-25%

Monthly Estimates of U.S. Stock Market Daily Volatility 1926 – 1997

6%
5%
4%
3%
2%
1%
0%
Jan 26 Jan 36 Jan 46 Jan 56 Jan 66 Jan 76 Jan 86 Jan 96

Anomalies: The Size Effect, 1964 – 2004 15.401
16.0
14.0
12.0
10.0
8.0
Small 2 3 4 5 6 7 8 9 Big
Firms sorted by MARKET CAPITALIZATION

Anomalies: The January Effect, 1964 – 2004 15.401
9%
8% All Months Januarys
7%
6%
5%
4%
3%
2%
1%
0%
Small 2 3 4 5 6 7 8 9 Big
Firm s sorted by MARKET CAPITALIZATION

Anomalies: The Value Premium, 1964 – 2004 15.401
18%
16%
14%
12%
10%
8%
Low 2 3 4 5 6 7 8 9 High
Firms sorted by PRICE / BOOK EQUITY

Anomalies: Momentum, 1964 – 2004 15.401
18%
15%
12%
9%
6%
3%
Low 2 3 4 5 6 7 8 9 High
Firms sorted by PAST 12-MONTH RETURN

Anomalies: The Accrual Effect, 1964 – 2004 15.401
15.0
13.0
11.0
9.0
7.0
5.0
3.0
Low 2 3 4 5 6 7 8 9 High
Firms sorted by last year's OPERATING ACCRUALS
*Operating income minus operating cashflows

Anomalies: IPO Returns, 1970 – 1990 15.401
Average Annual Returns, 1 – 5 Years After IPO
14.1% 14.3%
16% 13.3%
11.3%
12%
11.6%
6.1%
8%
4% 5.0%
3.6% 4.0%
1.6% Non-issuers
IPOs
0%
1st year 2nd year 3rd year 4th year 5th year

Anomalies: SEO Returns, 1970 – 1990 15.401
Average Annual Returns, 1 – 5 Years After SEO
17.7% 17.4%
20%
16.2%
12.9% 12.3%
15%
11.8%
10%
9.1%
7.5%
6.6%
5%
Non-issuers
0.3% SEOs
0%
1st year 2nd year 3rd year 4th year 5th year

Anomalies: Takeover Announcements 15.401
Stock price of TARGET
40%
Cumulative average abnormal returns
30%
20%
10%
0%
-10%
-126 -105 -84 -63 -42 -21 0 21 42 63 84 105 126 147 168 189 210 231 252
Event date relative to first bid
Successful All Unsuccessful
Stock Price of TARGET

Image by MIT OpenCourseWare.

Anomalies: Performance of Mutual Funds 15.401
36
32
28
24
# Frequency
20
16
12
0
-3 -2 -1 0 1 2
Midpoint
Estimates of individual mutual-fund alphas 1972 to 1991. The frequency distribution
of estimated alphas for all equity mutual funds with 10-year continuous records.
Image by MIT OpenCourseWare.

Key Points 15.401
Observations
The average annual return on U.S. stocks from 1926 – 2004 was 11.2%.
The average risk premium was 7.8%.
Stocks are quite risky. The standard deviation of returns for the overall
market is 4.5% monthly (16.4% annually).
Individual stocks are much riskier. The average monthly standard
deviation of an individual stock is around 17% (or 50% annually).
Stocks tend to move together over time: when one stock goes up, other
stocks are likely to go up as well. The correlation is far from perfect.
Stock returns are nearly unpredictable. For example, knowing how a stock
does this month tells you very little about what will happen next month.
Market volatility changes over time. Prices are sometimes quite volatile.
The standard deviation of monthly returns varies from roughly 2% to 20%.
Financial ratios like DY and P/E ratios vary widely over time. DY hit a
maximum of 13.8% in 1932 and a minimum of 1.17% in 1999. The P/E ratio
hit a maximum of 33.4 in 1999 and a minimum of 5.3 in 1917.

Key Points 15.401
Anomalies:
Size Effect: Smaller stocks typically outperform larger stocks,
especially in January.
January Effect: Returns in January tend to be abnormally high.
Value Effect: Low P/B (value) stocks typically outperform high P/B
(growth) stocks.
Momentum: Stocks with high returns over the past 12 months
typically continue to outperform stocks with low past returns.
Accruals and Issuances: Stocks with high past accruals and/or
recent stock offerings typically underperform stocks with low past
accruals and no stock offerings.

Additional References 15.401
Lefevre, E., 2006, Reminiscences of a Stock Operator. New York: John Wiley & Sons.
Malkiel, B., 1996, A Random Walk Down Wall Street: Including a Life-Cycle Guide to Personal
Investing. New York: W.W. Norton.

MIT OpenCourseWare
http://ocw.mit.edu
15.401 Finance Theory I

Fall 2008
For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms.

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15.

15.401 Finance Theory

Lecture 12: Introduction to Risk and Return

© 2007–2008 by Andrew W. Lo Slide 2

NPV and Other Valuation Techniques Need Cost of Capital

Introduce Risk Into The Valuation Process

© 2007–2008 by Andrew W. Lo Slide 3

© 2007–2008 by Andrew W. Lo Slide 4

© 2007–2008 by Andrew W. Lo Slide 5

© 2007–2008 by Andrew W. Lo Slide 6

Negatively Skewed Distribution

© 2007–2008 by Andrew W. Lo Slide 7

Examples of Correlation Between Two Random Variables

© 2007–2008 by Andrew W. Lo Slide 8

© 2007–2008 by Andrew W. Lo Slide 9

© 2007–2008 by Andrew W. Lo Slide 10

What Characterizes U.S. Stock Returns?

What Properties Should Stock Prices Have In “Efficient” Markets?

© 2007–2008 by Andrew W. Lo Slide 11

Predictable Price Changes

© 2007–2008 by Andrew W. Lo Slide 12

Random Walks with Drift

© 2007–2008 by Andrew W. Lo Slide 13

Four facts from history of U.S. financial markets:

Basic Statistics, U.S., 1946 – 2001 (monthly,in percent)

NYSE, Amex, NASDAQ: 6,700 firms, $16.4 trillion market cap

© 2007–2008 by Andrew W. Lo Slide 14

Total Return of Stocks, Bonds, Bills and Inflation 1946 – 2001

© 2007–2008 by Andrew W. Lo Slide 15

Interest Rates 1953 – 2001

© 2007–2008 by Andrew W. Lo Slide 16

Total Returns, 10-Year U.S. T-Bond, 1946 – 2001

© 2007–2008 by Andrew W. Lo Slide 17

Total Returns, U.S. Stock Market 1946 – 2001

© 2007–2008 by Andrew W. Lo Slide 18

Total Returns, Motorola 1946 – 2001

© 2007–2008 by Andrew W. Lo Slide 19

Scatterplot, VWRETD Today vs. Yesterday ,1980 – 1999

© 2007–2008 by Andrew W. Lo Slide 20

© 2007–2008 by Andrew W. Lo Slide 21

Scatterplot GM vs. S&P 500 Monthly Returns, 1946 – 1997

© 2007–2008 by Andrew W. Lo Slide 22

Monthly Estimates of U.S. Stock Market Daily Volatility 1926 – 1997

© 2007–2008 by Andrew W. Lo Slide 23

© 2007–2008 by Andrew W. Lo Slide 24

© 2007–2008 by Andrew W. Lo Slide 25

© 2007–2008 by Andrew W. Lo Slide 26

© 2007–2008 by Andrew W. Lo Slide 27

© 2007–2008 by Andrew W. Lo Slide 28

Average Annual Returns, 1 – 5 Years After IPO

© 2007–2008 by Andrew W. Lo Slide 29

Average Annual Returns, 1 – 5 Years After SEO

© 2007–2008 by Andrew W. Lo Slide 30

Stock price of TARGET

Event date relative to first bid

Successful All Unsuccessful

Stock Price of TARGET

© 2007–2008 by Andrew W. Lo Slide 31

© 2007–2008 by Andrew W. Lo Slide 32

© 2007–2008 by Andrew W. Lo Slide 33

© 2007–2008 by Andrew W. Lo Slide 34

© 2007–2008 by Andrew W. Lo Slide 35

15.401 Finance Theory I