1. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.0 Chapter 10 Some Lessons from Capital Market History

2. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.1 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

3. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.2 Chapter Outline Returns The Historical Record Average Returns: The First Lesson The Variability of Returns: The Second Lesson Capital Market Efficiency

4. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.3 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 The greater the potential reward, the greater the risk This is called the risk-return trade-off

5. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.4 Dollar Returns 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

6. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.5 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

7. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.6 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%

8. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.7 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

9. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.8 The Great Bull Market of 1982 – 1999, “Bumps Along the Way” Period% Decline in S&P 500 Oct. 10, 1983 – July 24, 1984-14.4% Aug. 25, 1987 – Oct. 19, 1987-33.2% Oct. 21, 1987 – Oct. 26, 1987-11.9% Nov. 2, 1987 – Dec. 4, 1987-12.4% Oct. 9, 1989 – Jan. 30, 1990-10.2% July 16, 1990 – Oct. 11, 1990-19.9% Feb. 18, 1997 – Apr. 11, 1997-9.6% July 19, 1999 – Oct. 18, 1999-12.1%

10. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.9 Figure 10.4 Index $10,000 $1,000 $100 $10 $1 $0.1 1925 1935 1945 195519651975 Year-end 1985 1995 1999 Small-company stocks Large-company stocks Inflation Treasury bills Long-term government bonds $6,640.79 $2,845.63 $40.22 $15.64 $9.39

11. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.10 Year-to-Year Total Returns Large-Company Stock Returns Long-Term Government Bond Returns U.S. Treasury Bill Returns

12. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.11 Average Returns InvestmentAverage Return Large stocks13.3% Small Stocks17.6% Long-term Corporate Bonds5.9% Long-term Government Bonds5.5% U.S. Treasury Bills3.8% Inflation3.2%

13. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.12 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

14. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.13 Historical Risk Premiums Large stocks: 13.3 – 3.8 = 9.5% Small stocks: 17.6 – 3.8 = 13.8% Long-term corporate bonds: 5.9 – 3.8 =2.1% Long-term government bonds: 5.5 – 3.8 = 1.7%

15. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.14 Figure 10.9 19361937 1974 1930 1973 1966 1957 1941 1990 1981 1977 1969 1962 1953 1946 1940 1939 1934 1932 1929 1994 1993 1992 1987 1984 1978 1970 1960 1956 1948 1947 1988 1986 1979 1972 1971 1968 1965 1964 1959 1952 1949 1944 1926 1999 1998 1996 1983 1982 1976 1967 1963 1961 1951 1943 1942 1997 1995 1991 1989 1985 1980 1975 1955 1950 1945 1938 1936 1927 1956 1935 1928 1954 1933 1 1 2 4 12 11 13 2 3 0 -50-40-30-20-100102030405060708090 Return (%)

16. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.15 Variance and Standard Deviation 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

17. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.16 Example – Variance and Standard Deviation YearActual Return Average Return Deviation from the Mean Squared 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

18. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.17 Figure 10.10 90% Large-company stocks13.3%20.1 Small-company stocks17.633.6 Long-term corporate bonds5.98.7 Long-term government5.59.3 Intermediate-term government5.45.8 U.S. Treasury bills3.83.2 Inflation3.24.5 -90% 0% *The 1933 small-company stock total return was 142.9 percent. * Series Average Return Standard Deviation Distribution

19. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.18 Figure 10.11 -3  -47.0% -2  -26.9% -1  -6.8% 0 13.3% +1  33.4% +2  53.5% +3  73.6% Probability Return on large common stocks 68% 95% >99%

20. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.19 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 Efficient markets DO NOT imply that investors cannot earn a positive return in the stock market

21. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.20 Chapter 10 #12 -8-6-4-20+2+4+6+8 100 140 180 220 Price ($) Days relative to announcement day (Day 0) Overreaction and correction Delayed reaction Efficient market reaction Efficient market reaction: the price instantaneously adjusts to and fully reflects new information; there is no tendency for subsequent increases and decreases. Delayed reaction: The price partially adjusts to the new information; eight days elapse before the price completely reflects the new information. Overreaction and correction: The price over adjusts to the new information; it overshoots the new price and subsequently corrects.

22. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.21 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

23. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.22 Common Misconceptions about EMH Efficient markets do not mean that you can’t 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 don’t want to put all your eggs in one basket

24. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.23 Strong Form Efficiency Prices reflect all information, including public and private If the market is strong form efficient, then investors could not earn abnormal returns regardless of the information they possessed Empirical evidence indicates that markets are NOT strong form efficient and that insiders could earn abnormal returns

25. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.24 Semistrong Form Efficiency Prices reflect all publicly available information including trading information, annual reports, press releases, etc. If the market is semistrong form efficient, then investors cannot earn abnormal returns by trading on public information Implies that fundamental analysis will not lead to abnormal returns

26. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.25 Weak Form Efficiency Prices reflect all past market information such as price and volume If the market is weak form efficient, then investors cannot earn abnormal returns by trading on market information Implies that technical analysis will not lead to abnormal returns Empirical evidence indicates that markets are generally weak form efficient

27. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.26 Chapter 10 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?