Historical Equity Markets

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Key Concepts and Skills

• Know how to calculate the return on an

investment

• Understand the historical returns and risks to

various types of investments

• Understand the basic risk vs return trade-off

• Understand what is meant by an Efficient

Capital market

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Percentage Return to an Investment

• The ‘Percentage Return’ is the percentage

increase in the value of an investment at the
end of the period on its value at the
beginning.
• Thus if one pays Pt for an investment,
receives a dividend Dt during the period and
sells it for Pt+1 at the end
Dividend
Yield Price Return
or Capital Gain
or Income
! "
#$# %
Divt + Pt +1 - Pt Divt Pt +1 - Pt
Rt +1 = = +
Pt Pt Pt

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Example – Calculating Returns

• You bought a stock for $35 in Jan 1st and

you received dividends of $1.25 during the
year and the stock is selling for $40 on Dec
31st

– What is your annual percentage return?

§ Dividend yield = 1.25 / 35 = 3.57%

§ Capital gains yield = (40 – 35) / 35 =
14.29%
§ Total percentage return = 3.57 + 14.29 =
17.86%

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Arithmetic vs. Geometric Mean

• 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
– So the answer depends on the planning period under
consideration
§ 15 – 20 years or less: use arithmetic
§ 20 – 40 years or so: split the difference between them
§ 40 + years: use the geometric

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Example: Computing Averages

• What is the arithmetic and geometric

average for the following returns?
– Year 1 5%
– Year 2 -3%
– Year 3 12%
– Arithmetic average = (5 + (–3) + 12)/3 =
4.67%
– Geometric average =
[(1+.05)*(1-.03)*(1+.12)]1/3 – 1 = .0449 =
4.49%

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Real and Nominal Returns

• Nominal return is the percentage increase in money value,

the real return is the percentage increase in purchasing
power.

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Historical Performance of different Investments

Return to $100 Investment in 1925 ignoring tax and transactions costs

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Arithmetic Average Returns 1926-2014

Investment Average Standard

Return Deviation
Small stocks 18.8% 38.8%

S&P 500 12.0% 20.1%

Corporate Bonds 6.5% 7.0%

U.S. Treasury Bills 3.5% 3.1%

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The Historical Tradeoff Between Risk and Return in Large
Portfolios, 1926–2014

Note the almost linear relationship between volatility and returns for large portfolios.

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Risk, Return and Financial Markets

• Lessons from capital market history

– There is a reward for bearing risk
– The greater the risk, the greater the reward
demanded
– This is called the risk-return trade-off

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Risk Premiums

• The extra return earned for taking on risk. (Treasury bills are
considered to be risk-free)

Investment Average Risk Premium

Return
Small stocks 18.8% 15.3%

S&P 500 12.0% 8.5%

Corporate Bonds 6.5% 3.0%

U.S. Treasury Bills 3.5% 0.0%

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Efficient Capital Markets

• Stock prices are in equilibrium or are fairly priced

• If this is true, then you should not be able to earn

abnormal or excess returns, i.e. returns
disproportionate to the level of risk taken.

• Efficient markets DO NOT imply that investors cannot

earn a positive return in the stock market

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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 analyzed and trades are made
based on this information
– Therefore, prices should reflect all available public
information

• If investors stop researching stocks, then the market

will not be efficient

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Definitions of Market Efficiency

Definition Implication Empirical

Support
Strong Form Prices reflect all No investor can earn None
public and excess returns.
private
information.
Semi-Strong Prices reflect all Fundamental Some
Form public Analysis can not
information. earn excess returns
Weak Form Prices reflect all Technical Analysis Good
information in can not earn excess
market prices. returns

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