Chapter 12

Lessons From
Capital Market History

Prepared by Anne Inglis, CFA

Edited by Karen Chiykowski
© 2016 McGraw-Hill Education Limited
 Key Concepts and Skills
• Know how to calculate the return on an
investment
• Understand the historical returns on
various types of investments
• Understand the historical risks on various
types of investments
• Know the implications of market efficiency
• (above material covered in Week 7 along with
stock pricing)
© 2016 McGraw-Hill Education Limited 12-1
All Risk, Return and Financial
LOs
Markets
• We can examine returns in the financial
markets to help us determine the
appropriate returns on non-financial assets
• Lesson from capital market history
• There is a reward for bearing risk
• The greater the potential reward, the greater
the risk
• This is called the risk-return trade-off

© 2016 McGraw-Hill Education Limited 12-2

LO1
Dollar Returns 12.1
• Total dollar return = income from
investment + capital gain (loss) due to
change in price
• Example:
• You bought a bond for $950 1 year ago. You
have received two coupons of $30 each. You
can sell the bond for $975 today. What is your
total dollar return?
• Income = 30 + 30 = 60
• Capital gain = 975 – 950 = 25
• Total dollar return = 60 + 25 = $85
© 2016 McGraw-Hill Education Limited 12-3
LO1
Percentage Returns
• It is generally more intuitive to think in
terms of percentages than dollar returns
• Dividend yield = income / beginning price
• Capital gains yield = (ending price –
beginning price) / beginning price
• Total percentage return = dividend yield +
capital gains yield

© 2016 McGraw-Hill Education Limited 12-4

LO1
Example – Calculating Returns
• You bought a stock for $35 and you
received dividends of $1.25. The stock is
now selling for $40.
• Calculate the dollar return.

• Calculate the dividend return, capital gains

return and total percentage return.

© 2016 McGraw-Hill Education Limited 12-5

LO2
&
The Importance of Financial
LO3 Markets 12.2
• Financial markets are intermediaries which allow
companies, governments and individuals to
increase their utility
• Savers have the ability to invest in financial
assets so that they can defer consumption and
earn a return to compensate them for doing so
• Borrowers have access to the capital that is
available, (the saver’s investments) so that they
can invest in productive assets.
• Financial markets also provide us with
information about the returns that are required
for various levels of risk
© 2016 McGraw-Hill Education Limited 12-6
 Figure 12.4 – If you invested $1 in 1957,
LO2
how much would you have in 2014?

© 2016 McGraw-Hill Education Limited 12-7

LO2
Table 12.2 Average Returns
1957 – 2014
Arithmetic Average
Investment
Return (%)
Canadian common stocks 10.30
U.S.
$) common stocks (Cdn 11.73
Long bonds 8.57
Small stocks 12.81
TSX Venture stocks 7.16
Inflation 3.82
Treasury bills 5.88

© 2016 McGraw-Hill Education Limited 12-8

LO3
Risk Premiums
• The “incremental” return earned for taking
on risk
• Treasury bills are considered to be risk-
free
• The risk premium is the return over and
above the risk-free rate

© 2016 McGraw-Hill Education Limited 12-9

LO2
Table 12.3 Average Returns and
&
LO3 Risk Premiums 1957 – 2014

Investment Arithmetic Average return (%) Risk Premium (%)

Canadian common stocks 10.30
U.S. common stocks (Cdn $) 11.73
Long bonds 8.57
Small stocks 12.81
TSX Venture stocks 7.16
Inflation 3.82 -
Treasury bills 5.88

© 2016 McGraw-Hill Education Limited 12-10

LO3
Variance and Standard
Deviation 12.4
• Variance and standard deviation measure
the volatility of asset returns
• The greater the volatility, the greater the
uncertainty
• Slides at the end of the deck show how
standard deviation is calculated.
• It is assumed that you have seen standard
deviation in your undergrad courses or OMIS
courses.
• I expect you to understand but not calculate
© 2016 McGraw-Hill Education Limited 12-11
 Table 12.4 Historical Returns and
LO3
Standard Deviations 1957 – 2014
Investment Arithmetic Average return (%) Standard Deviation (%)
Canadian common stocks 10.30 16.50
U.S. common stocks (Cdn $) 11.73 16.94
Long bonds 8.57 9.78
Small stocks 12.81 25.96
TSX Venture stocks 7.16 44.35
Inflation 3.82 2.10
Treasury bills 5.88 3.83

© 2016 McGraw-Hill Education Limited 12-12

 Figure 12.6 – Normal Distribution and a
LO3
Portfolio of Large Common Stocks

© 2016 McGraw-Hill Education Limited 12-13

LO2
Figure 12.5 – Frequency distribution of
Returns on Canadian Common Stocks

© 2016 McGraw-Hill Education Limited 12-14

LO1
More on Average Returns 12.5
• There are many different ways of
calculating returns over multiple periods
• Two methods are:
• Arithmetic Average Return
• Tends to be used as a forward looking measure of
expected returns when the forward period is not
“too long”. To be conservative, over longer
periods, the average of the two returns is often
used.
• Geometric Average Return
• Most often used to calculate past or historical
returns which© 2016
should include
McGraw-Hill compounding.
Education Limited 12-15
LO1 Arithmetic vs. Geometric Average Example

• You invested $100 in a stock five years

ago. Over the last five years, annual
returns have been 15%, -8%, 12%, 18%
and -11%.
• Calculate
1.the value of your investment today.
2.the average arithmetic return.
3.the average geometric return.

© 2016 McGraw-Hill Education Limited 12-16

Geometric vs Arithmetic returns
• Notice average arithmetic return is greater
than the average geometric return
• 5.2% vs 4.7%

• What explains the difference in arithmetic

and geometric returns?

12-17
 Figure 12.4 – If you invested $1 in 1957,
LO2
how much would you have in 2014?

© 2016 McGraw-Hill Education Limited 12-18

LO1
Geometric Average
• Calculate the geometric average returns for
Canadian stocks as measured by the
S&P/TSX composite index between 1957 and
2015.

• The general formula for calculating the

geometric average return is the following:
Geometric Average Return  1  R 1  1  R 2  ...  1  R T   1
1
T

© 2016 McGraw-Hill Education Limited 12-19

LO1
Geometric vs. Arithmetic Average
Returns 1957-2014
Average Return

Investment Arithmetic (%) Geometric (%) Standard deviation (%)

Canadian common stocks 10.30 9.01 16.50
U.S. common stocks (Cdn $) 11.73 10.42 16.94
Long bonds 8.57 8.16 9.78
Small stocks 12.81 9.83 25.96
TSX Venture stocks 7.16 2.69 44.35
Inflation 3.82 3.77 3.10

© 2016 McGraw-Hill Education Limited 12-20

• The following slides are helpful for
students who have no stats or need a
refresher on calculating averages and
standard deviations.

12-21
LO1
Calculating Arithmetic Average

15  (8)  12  18  (11)
Arithmetic Average Return  RA 
5

R A  5.2

• The arithmetic return in an average year was 5.2%.

© 2016 McGraw-Hill Education Limited 12-22

LO1 Calculating Geometric Average Continued

• What equivalent rate of return would you have to earn

every year on average to achieve this same future
wealth?

$124.44  $100  (1  RG ) 5

1
RG  1.2444 5  1
RG  4.47%
• Your average geometric return was 4.47% each year.

© 2016 McGraw-Hill Education Limited 12-23

LO3
Variance and Standard
Deviation 12.4
• Variance and standard deviation measure
the volatility of asset returns
• The greater the volatility, the greater the
uncertainty
• Historical variance = sum of squared
deviations from the mean / (number of
observations – 1)
• Standard deviation = square root of the
variance
© 2016 McGraw-Hill Education Limited 12-24
 Example – Variance and
LO3
Standard Deviation
Year Actual Average Deviation from Squared
Return Return the Mean Deviation
1 .15 .105 .045 .002025

2 .09 .105 -.015 .000225

3 .06 .105 -.045 .002025

4 .12 .105 .015 .000225

Totals .42 .00 .0045

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

© 2016 McGraw-Hill Education Limited 12-25

 Quick Quiz
• Which of the investments discussed have
had the
• highest average return?
• Standard deviation
• risk premium?

© 2016 McGraw-Hill Education Limited 12-26

 Summary 12.7
• You should know that:
• Risky assets earn a risk premium
• Risk can be measured by standard deviation
or variance
• Greater risk requires a larger required return

© 2016 McGraw-Hill Education Limited 12-27