1. 12-0 Some Lessons from Capital Market History Chapter 12 Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

2. Chapter Outline Return Definitions Dollar Return vs. Percentage Return Historical Returns Average Returns & Variability of Returns Capital Market Efficiency 1

3. Return Definitions: Dollar Returns Total dollar return = income from investment + capital gain (loss) due to change in price 2

4. Return Definitions: Percentage Returns Total percentage return = (income from investment + capital gain) beginning price 3

5. Return Example You buy a stock for $20 per share. At the end of the year the price is $30 per share. During the year you received a $3 dollar dividend per share. 1. What is the dividend yield? 2. What is the capital gains yield? 3. What is the total percentage return? 4

6. Return Example In the previous example, if you had invested $1,000, how much in dividends, capital gain, and total dollar return would you have received? 5

7. Historical Returns, 1925-2010 Risk Premium 6

8. Risk Premiums Risk Premium: The “extra” return earned for taking on risk Risk premium = return - risk free rate Treasury bills are considered to be risk-free 7

9. Historical Returns: Average Returns Average Returns = sum of returns / # of observations (T) 8

10. Historical Returns: Variance and Standard Deviation of Returns Variance and standard deviation measure the volatility of asset returns Historical variance = sum of squared deviations from the mean / (number of observations – 1) Standard deviation = square root of the variance 9

11. Example Calculate the average return and the standard deviation for the following return series: Year Return Avg. Return Deviation Deviation 2 2007 0.30 2008 0.45 2009 0.12 2010 -0.15 2011 0.24 10

12. Summary of Historical Returns 1926-2010 11

13. Normal Distribution A large enough sample drawn from a normal distribution looks like a bell-shaped curve. In what range do the returns of large company stocks fall 68% (2/3) of the time? Avg: 11.9%, SD: 20.4% Range = avg. return +/- z (SD) =>.119 +/- 1(.204)= & 12 68% => z=1 95% => z=2 99% => z=3

14. 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. Three forms of market efficiency: - weak, semi-strong, and strong-form 13

15. Forms of Market Efficiency Weak Form: Prices reflect all past (historical) market information such as price and volume =>abnormal returns cannot be earned based on historical information Semi-Strong Form: Prices reflect all publicly available information including trading information, annual reports, press releases, etc. =>abnormal returns cannot be earned based on public information Strong Form: Prices reflect all information, including public and private =>abnormal returns cannot be earned based on private information 14

16. The Record of Mutual Funds Taken from Lubos Pastor and Robert F. Stambaugh, “Mutual Fund Performance and Seemingly Unrelated Assets,” Journal of Financial Economics, 63 (2002). Annual return performance of different types of US mutual funds relative to a broad-based market index (1963 – 1998).

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