Some Lessons from Capital Market History

1
Some Lessons from Capital Market History

• Chapter 10

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Chapter Outline

• Returns
• The Historical Record
• Average Returns The First Lesson
• The Variability of Returns The Second Lesson
• Capital Market Efficiency

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Key Concepts and Skills

• Know how to calculate the return on an investment
• Returns Percentage versus Dollar returns
• Understand the historical returns on various
  types of investments
• Small stocks on average outperformed all other
  assets classes on long term (during the last 80
  years)
• Understand the historical risks on various types
  of investments
• Small stocks are associated with the highest risk
  (highest variation in returns), in comparison
  with large stocks, corporate bonds or Treasury
  bonds

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Risk, Return and Financial 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.
• You can potentially earn much higher return on
  stock investments than on your saving account,
  but there is a possibility of loosing on a stock
  investment, while a saving account offers capital
  preservation.
• The risk-return trade-off means that the greater
  the potential reward, the greater the risk.
• In stock speculation (or betting) the
  probability of gain is small, and you as an
  investor want to be compensated for this by the
  possibly greater return.

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Dollar Returns

• Total dollar return income from investment
  capital gain (loss)
• 
  due to change in
  price
• Example 1 You bought a bond for 950 last year.
  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 Sale price Purchase price 975
  950 25
• Total dollar return 60 25 85
• Example 2 You bought a stock for 20 last year
  (12 month ago). The stock paid quarterly
  dividends of .50. You can sell the stock for 24
  today. What is your total dollar return?
• Income (dividends) 4 times .5 2 (is the
  income in form of dividend)
• Capital gain (gain/loss due to price change) 24
  20 4
• Total dollar return 42 6

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Percentage Returns

• It is generally more intuitive to think in terms
  of percentages than dollar returns.
• Total percentage return Dividend yield
  Capital gains yield
• Dividend yield Income / Beginning price
• Capital gains yield (Ending price Beginning
  price) / Beginning price
• Example 2 contd. You bought a stock for 20 last
  year. The stock paid quarterly dividends of .50
  (assume you received 4 payments). You can sell
  the stock for 24 today. What is your percentage
  return?
• Dividend yield 2/ 20 10
• Capital gains yield (24 20) / 20 20
• Total percentage return 10 20 30

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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
• Shortcut for percentage return
• If you know the dollar return, then the
  percentage return is simply, Total percentage
  return Dollar return / Purchase price 6.25/35

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The Importance of Financial Markets

• Financial markets 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 better access to the capital that
  is available 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

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Figure 10.4 from page 297
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Average Returns 1926 - 2004
See Table 10.3 on p.302
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Risk Premiums

• The extra 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
• Historical risk premiums (using Table 3 from
  p.302)
• Large stocks 12.4 3.8 8.6
• Small stocks 17.5 3.8 13.7
• Long-term corporate bonds 6.2 3.8 2.4
• Long-term government bonds 5.8 3.8 2

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Variance and Standard Deviation

• Variance and standard deviation measure the
  volatility of asset returns
• The greater the volatility the greater the
  uncertainty (which means greater risk is
  associated with the specific investment)
• Historical variance sum of squared deviations
  from the mean / (number of observations 1)
• Standard deviation square root of the variance

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Book Example Variance Standard Dev.
Variance (Var) .027 / (4-1) .009 Standard
Deviation (Std. Dev) .09487 Why are we
interested in the Variance? Because, we want to
know how risky our investment is.
See Example on p. 304.
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Class Example Variance Std. Dev.
Variance (Var) .353 / (4-1) .1177 Standard
Deviation (Std. Dev) .343
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Figure 10.9 Frequency distribution of

common stocks 1926-2004
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Figure 10.10 Historical returns
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Figure 10.11 - Probability distribution
Stock returns are random numbers. Thus, with
certainty, we do not know the future returns. The
probability distribution is informative about the
chances that the return will be within a certain
range or outside a certain range. In general the
probability, that the return in a given year is
within the range of plus or minus one Std. Dev.
from the mean (average historical return) is 68.
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Figure 10.11 - Probability distribution cont
With 68 probability in a given year, the return
is within -7.9 and 32.7. Alternatively, with
32 (1-.68) probability the return, in a given
year is outside the range of -7.9 and 32.7.
Similarly, with 95 probability the return, in a
given year, is within the range of -28.2 and
53.0.
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Class Example contd Var. Std. Dev.
Using actual stock information we calculated the
average return (10.3) and the standard deviation
(34.3) of the asset. Now, I want to know in
which range can I expect the return to be next
year with 68 probability. Also, I want to know
the probability that the return will be less than
-24, because I am concerned about excessive loss.
1Std.Dev
1Std.Dev
Average return (10.3)
-24
44.6
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Arithmetic vs. Geometric Mean

• Consider annual returns of 10, 12, 3 and -9
• Arithmetic mean (.1 .12 .03 - .09)/4 .04
  4
• Rate earned in a typical year
• Geometric mean (1.1 x 1.12 x 1.03 x .91)1/4
  1 .0366 3.66
• Rate earned per year, allowing for annual
  compounding

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Example 10.4
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Work the Web Example

• How volatile are mutual funds?
• Morningstar provides information on mutual funds,
  including volatility
• Click on the web surfer to go to the Morningstar
  site
• Pick a fund, such as the Aim European Development
  fund (AEDCX)
• Enter the ticker, press go and then scroll down
  to volatility
• Or use this Link to AIM

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Efficient Capital Markets

• Efficient Capital market is a market where 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
  (consistently, while you may have luck sometimes)
• Efficient markets DO NOT imply that investors
  cannot earn a positive return in the stock market
• What makes the market 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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Figure 10.12
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Common Misconceptions about EMH

• Efficient markets do not mean that you cant make
  money
• They do mean that, on average, you will earn a
  return that is appropriate for the risk
  undertaken and there is not a bias in prices that
  can be exploited to earn excess returns
• Market efficiency will not protect you from wrong
  choices if you do not diversify you still dont
  want to put all your eggs in one basket

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Market Efficiency
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Quick Quiz

• Which of the investments discussed have had the
  highest average return and risk premium?
• Which of the investments discussed have had the
  highest standard deviation?
• What is capital market efficiency?
• What are the three forms of market efficiency?