Chapter 7

An Introduction to Risk and Return—History

of Financial Market Returns

 Chapter Overview
This chapter introduces the concepts of risk and return as used in finance. In general, there is a risk-return
tradeoff; that is, more risky investments are expected to realize higher returns on average. Various
statistical measures aid in developing measures of risk and return.

Realized return is the gain or loss we actually experience on a stock during a period. Expected return is an
average over the range of possible realized returns. Risk is measured by the variability in the returns on the
stock. As such, this variability is captured by the standard deviation or variance of returns over the range
of possible realized returns.

Historical returns offer insight into the risk-return tradeoff. In general, riskier investments have historically
realized higher returns. Further, the historical returns of the higher-risk investment classes have higher
standard deviations—i.e., risk.

The Efficient Markets Hypothesis states that security prices accurately reflect future expected cash flows
and are based on all information available to investors. Three forms of market efficiency are explored:
Weak-Form Efficiency, Semi-Strong-Form Efficiency, and Strong-Form Efficiency.

 Chapter Overview
7.1 Realized and Expected Rates of Return and Risk
A. The gain or loss on a stock that we actually experience during a period is called the realized rate
of return.
1. This return consists of both dividend payments and capital gains (loss).
2. This can be positive or negative for any period.
B. The expected rate of return is the weighted average of the possible returns where each possible
return is weighted by the probability that it occurs.
C. Risk is measured by calculating the variance of the possible rates of return.

7.2 A Brief History of Financial Market Returns

A. The riskiest investment class is comprised of International stocks followed by U.S. stocks, then
corporate bonds, U.S. government bonds, and Treasury bills.
B. The historical returns of the higher-risk investment classes have higher standard deviations.

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21  Titman/Keown/Martin  Financial Management, Thirteenth Edition, Global Edition

C. A similar risk-return tradeoff is found in international investing: Returns and risk are higher for
emerging markets stocks compared to equities of developed countries.
7.3 Geometric vs. Arithmetic Average Rates of Return
A. To find the arithmetic average of rates of return, add the rates together and divide by the number
of observations.
1. The arithmetic average should be used to determine the rate of return to expect for the next
year.
2. This measure is only appropriate when we are considering future periods that are equal in
duration to the past periods used in calculating this measure.
B. The geometric average answers the questions, “What was the growth rate of your investment?”
1. The geometric average is used to answer the question, “What annual rate of return can we
expect over a multi-year horizon?”

7.4 What Determines Stock Prices?

A. An efficient market is a market in which all the available information is fully incorporated into
the prices of the securities, and the returns investors earn on their investments cannot be
predicted.
B. There are three types of market efficiency:
1. Weak-Form Efficiency asserts that all past security market information is fully reflected in
security prices.
2. Semi-Strong Form Efficiency asserts that all publicly available information is fully
reflected in security prices.
3. Strong-Form Efficiency asserts that all information, public and private, is fully reflected in
security prices.

 Learning Objectives
7-1. Calculate realized and expected rates of return and risk.

7-2. Describe the historical pattern of financial market returns.

7-3. Compute geometric (or compound) and arithmetic average rates of return.

7-4. Explain the efficient market hypothesis and why it is important to stock prices.

 Lecture Tips
1. Use real-world information on a variety of stocks to calculate the holding-period returns over a given
timeframe. This could be done by accessing an internet site during class.

2. Discuss some ways that investors can invest in international stocks.

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 Chapter 7 An Introduction to Risk and Return—History of Financial Market Returns 22

 Questions for Further Class Discussion

1. Looking at Figure 7-4, analyze the comparative levels of risk and return for the various areas of the
world. Can the risk-return tradeoff fully explain the magnitude of the differences in return for these
various regions?

2. As an investor, what would you see as the pros and cons of international investment?

3. What does the financial crisis of 2008 suggest about market efficiency?

 End-of-Chapter Problem Complexity Rating

The end-of-chapter problems are sorted below, according to their level of complexity.

Simple Average Complex

1, 3, 4, 5 2, 6, 7, 8, 9 10

 Spreadsheet Solutions in Excel

The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets
are available on the Instructor’s Resource Center at www.pearsonhighered.com. If you do not have a login
and password for this Web site, contact your Pearson sales representative.

Problems: 7-1—10

 Internet Resources
http://www.rce.rutgers.edu/money/riskquiz

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