CHAPTER 10

SOME LESSONS FROM CAPITAL MARKET

HISTORY

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 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

• Understand the implications of market efficiency

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 CHAPTER OUTLINE
• Returns
• The Historical Record
• Average Returns:
The First Lesson
• The Variability of Returns:
The Second Lesson
• More about Average Returns
• Capital Market Efficiency

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RISK ANALYSIS

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RISK, RETURN, AND FINANCIAL
MARKETS

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DOLLAR RETURNS

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PERCENTAGE RETURNS

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 EXAMPLE: CALCULATING
RETURNS
• You bought a stock for $35, and you received
dividends of $1.25. The stock is now selling for
$40.
 What is your dollar return?
• Dollar return = 1.25 + (40 – 35) = $6.25

 What is your 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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THE IMPORTANCE OF FINANCIAL
MARKETS

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 FIGURE 12.4

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YEAR-TO-YEAR TOTAL RETURNS
Large-Company Stock Returns
Large Companies

Long-Term Government
Bond Returns Long-Term Government Bonds

U.S. Treasury Bill Returns

U.S. Treasury Bills

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 AVERAGE RETURNS
Investment Average Return
Large Stocks 12.1%
Small Stocks 16.9%
Long-term Corporate 6.3%
Bonds
Long-term Government 5.9%
Bonds
U.S. Treasury Bills 3.5%
Inflation 3.0%
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 12-13
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TABLE 12.3: AVERAGE ANNUAL
RETURNS AND RISK PREMIUMS
Investment Average Return Risk Premium

Large Stocks 12.1% 8.6%

Small Stocks 16.9% 13.4%

Long-term Corporate 6.3% 2.8%

Bonds
Long-term Government 5.9% 2.4%
Bonds
U.S. Treasury Bills 3.5% 0.0%

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 FIGURE 12.9

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VARIANCE AND STANDARD
DEVIATION

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 EXAMPLE: VARIANCE AND
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

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WORK THE WEB EXAMPLE

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 FIGURE 12.10

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NORMAL DISTRIBUTION

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 FIGURE 12.11

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RECENT MARKET VOLATILITY
• 2008 was one of the worst years for stock market
investors in history
 The S&P 500 plunged 37 percent
 The index lost 17% in October alone

• From March ‘09 to Feb ‘11, the S&P 500 doubled in

value

• Long-term Treasury bonds gained over 40 percent in

2008
 They lost almost 26 percent in 2009

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ARITHMETIC VS. GEOMETRIC
MEAN

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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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EFFICIENT CAPITAL MARKETS

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 FIGURE 12.14

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WHAT MAKES MARKETS
EFFICIENT?

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COMMON MISCONCEPTIONS
ABOUT EMH

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 12-29
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 12-30
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 12-31
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 BEHAVIORAL CHALLENGES

• Overconfidence
• Anchoring
• Sentiment
• Information is not even: My current work
END OF CHAPTER