Chapter 10

Risk and Return: Lessons from Market History

 Know how to calculate the return on an investment

 Know how to calculate the standard deviation of an
investment’s returns
 Understand the historical returns and risks on various
types of investments
 Understand the importance of the normal distribution
 Understand the difference between arithmetic and
geometric average returns

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 10.1 Returns
10.2 Holding-Period Returns
10.3 Return Statistics
10.4 Average Stock Returns and Risk-Free Returns
10.5 Risk Statistics
10.6 More on Average Returns
10.7 The U.S. Equity Risk Premium: Historical and
International Perspectives
10.8 2008: A Year of Financial Crisis

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10-2

 Dollar Returns
the sum of the cash received and Dividends
the change in value of the asset,
in dollars.
Ending
market value

Time 0 1
Percentage Returns
–the sum of the cash received and the
Initial change in value of the asset, divided
investment by the initial investment.

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 Dollar Return = Dividend + Change in Market Value
dollar return
percentage return =
beginning market value

dividend + change in market value

=
beginning market value

= dividend yield + capital gains yield

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 4

 Suppose you bought 100 shares of XYZ Co. one

year ago today at $45. Over the last year, you
received $27 in dividends (27 cents per share ×
100 shares). At the end of the year, the stock sells
for $48. How did you do?
 You invested $45 × 100 = $4,500. At the end of
the year, you have stock worth $4,800 and cash
dividends of $27. Your dollar gain was $327 = $27
+ ($4,800 – $4,500).
 Your percentage return for the year is:
$327
7.3% =
$4,500
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 Dollar Return:
$27
$327 gain
$300

Time 0 1
Percentage Return:
$327
-$4,500 7.3% =
$4,500

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10-6

 You bough 10 shares one year ago at $20.

 You have just received $1 dividend per share
and then sold your investment at $21 per
share.
 What is your total dollar return?
 What is dividend yield and capital gain?
 What is total percentage return?

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  The holding period return is the return that an
investor would get when holding an investment over
a period of T years, when the return during year i is
given as Ri:

Value = $1 (1 + R1 )  (1 + R2 )   (1 + RT )

HPR = (1 + R1 )  (1 + R2 )   (1 + RT ) − 1

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 Suppose your investment provides the following

returns over a four-year period:

Year Return Your holding period return =

1 10%
= (1+ R1 )  (1+ R2 )  (1+ R3 )  (1+ R4 ) −1
2 -5%
3 20% = (1.10)  (.95)  (1.20)  (1.15) −1
4 15%
= .4421 = 44.21%

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  A famous set of studies dealing with rates of returns on
common stocks, bonds, and Treasury bills was conducted
by Roger Ibbotson and Rex Sinquefield.
 They present year-by-year historical rates of return
starting in 1926 for the following five important types of
financial instruments in the United States:
◦ Large-company Common Stocks
◦ Small-company Common Stocks
◦ Long-term Corporate Bonds
◦ Long-term U.S. Government Bonds
◦ U.S. Treasury Bills
 Which one has highest return? Lowest return?
 What are their spread/dispersion?

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 The history of capital market returns can be

summarized by describing the:
◦ average return/mean ( R1 +  + RT )
R=
T
◦ the standard deviation of those returns
(R1 − R) 2 + (R2 − R) 2 +L (RT − R) 2
SD = VAR =
T −1
◦ the frequency distribution of the returns

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 Average Standard
Series Annual Return Deviation Distribution

Large Company Stocks 12.1% 20.1%

Small Company Stocks 16.7 32.1

Long-Term Corporate Bonds 6.4 8.4

Long-Term Government Bonds 6.1 10.0

U.S. Treasury Bills 3.5 3.1

Inflation 3.0 4.1

– 90% 0% + 90%

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 The Risk Premium is the added return (over and above the
risk-free rate) resulting from bearing risk.
 One of the most significant observations of stock market data
is the long-run excess of stock return over the risk-free return.
◦ The average excess return from large company common stocks for
the period 1926 through 2014 was:
8.6% = 12.1% – 3.5%
◦ The average excess return from small company common stocks for
the period 1926 through 2014 was:
13.2% = 16.7% – 3.5%
◦ The average excess return from long-term corporate bonds for the
period 1926 through 2014 was:
2.6% = 6.1% – 3.5%
 Sharpe ratio = risk premium/standard deviation
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  Suppose that The Wall Street Journal announced that
the current rate for one-year Treasury bills is 2%.
 What is the expected return on the market of small-
company stocks?
 Recall that the average excess return on small
company common stocks for the period 1926 through
2014 was 13.2%.
 Given a risk-free rate of 2%, we have an expected
return on the market of small-company stocks of
15.2% = 13.2% + 2%

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18%

Small-Company Stocks
16%
Annual Return Average

14%

12% Large-Company Stocks

10%

8%

6%
T-Bonds
4% T-Bills
2%
0% 5% 10% 15% 20% 25% 30% 35%

Annual Return Standard Deviation

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  There is no universally agreed-upon definition of
risk.
 The measures of risk that we discuss are variance and
standard deviation.
◦ The standard deviation is the standard statistical measure of
the spread of a sample, and it will be the measure we use
most of this time.
◦ Its interpretation is facilitated by a discussion of the normal
distribution.

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 A large enough sample drawn from a normal

distribution looks like a bell-shaped curve.
Probability

The probability that a yearly return

will fall within 20.1 percent of the
mean of 12.1 percent will be
approximately 2/3.

– 3s – 2s – 1s 0 + 1s + 2s + 3s
– 48.2% – 28.1% – 8.0% 12.1% 32.2% 52.3% 72.4% Return on
large company common
68.26% stocks
95.44%

99.74%
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  The 20.1% standard deviation we found for large
stock returns from 1926 through 2014 can now be
interpreted in the following way:
◦ If stock returns are approximately normally distributed, the
probability that a yearly return will fall within 20.1 percent
of the mean of 12.1% will be approximately 2/3.

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Year Actual Average Deviation from the Squared

Return Return Mean Deviation
1 .15 .105 .045 .002025

2 .09 .105 -.015 .000225

3 .06 .105 -.045 .002025

4 .12 .105 .015 .000225

Totals .00 .0045

Variance = .0045 / (4-1) = .0015 Standard Deviation = .03873

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  Arithmetic average – return earned in an average period
over multiple periods
 Geometric average – average compound return per period
over multiple periods
 The geometric average will be less than the arithmetic
average unless all the returns are equal.
 Which is better?
◦ The arithmetic average is overly optimistic for long
horizons.
◦ The geometric average is overly pessimistic for short
horizons.

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 Recall our earlier example:

Year Return Geometric average return =

1 10% (1+ Rg ) 4 = (1+ R1 )  (1+ R2 )  (1+ R3 )  (1+ R4 )
2 -5%
3 20% Rg = 4 (1.10)  (.95)  (1.20)  (1.15) −1
4 15% = .095844 = 9.58%
So, our investor made an average of 9.58% per year, realizing a
holding period return of 44.21%.
 1.4421 = (1.095844) 4
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

11
  Note that the geometric average is not the same as the
arithmetic average:

Year Return R1 + R2 + R3 + R4
1 10% Arithmetic average return =
2 -5%
4
3 20% 10% − 5% + 20% +15%
= = 10%
4 15% 4


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Arithmetic Geometric

R1... + ...RT Geometric average return =

Ra =
T Rg = T (1 + R1 )  ...  (1 + RT ) − 1

Yearly compounded return Typical year return

( R1 − R) 2 + ( R2 − R) 2 + ( RT − R) 2
SD = VAR =
T −1

Ra  Rg

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  Which of the investments discussed has had the
highest average return and risk premium?
 Which of the investments discussed has had the
highest standard deviation?
 Why is the normal distribution informative?
 What is the difference between arithmetic and
geometric averages?

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