12 Lessons From Capital Market History Prepared by Anne Inglis Edited by William Rentz

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. © 2013 McGraw-Hill Ryerson Limited

© 2013 McGraw-Hill Ryerson Limited Chapter Outline Returns The Historical Record Average Returns: The First Lesson The Variability of Returns: The Second Lesson More on Average Returns Capital Market Efficiency © 2013 McGraw-Hill Ryerson Limited

Risk, Return and Financial Markets All LOs 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 © 2013 McGraw-Hill Ryerson Limited

© 2013 McGraw-Hill Ryerson Limited Returns 12.1 LO1 Total dollar return = Income from investment + Capital gain (loss) due to change in price Total percentage return = Total dollar return / Beginning price = Income yield* + Capital gains yield *The income yield is called the current yield for a bond and the dividend yield for a stock. Be sure to emphasize that you do not have to actually sell the stock for you to earn the dollar return. The point is that you could. © 2013 McGraw-Hill Ryerson Limited

Example 1 – Calculating Returns LO1 You bought a bond for $950 1 year ago You received TWO coupons of $30 EACH You can sell the bond for $975 today What is your total dollar return? What is your total percentage return? Be sure to emphasize that you do not have to actually sell the stock for you to earn the dollar return. The point is that you could. © 2013 McGraw-Hill Ryerson Limited

Example 1 – Calculating Returns (continued) LO1 What is your total dollar return? Income = $30 + $30 = $60 Capital gain = $975 – $950 = $25 Total dollar return = $60 + $25 = $85 What is your total percentage return? Current yield = $60 / $950 = .0632 or 6.32% Capital gain = $25 / $950 = .0263 or 2.63% Total percentage return = 6.32% + 2.63% = 8.95% Be sure to emphasize that you do not have to actually sell the stock for you to earn the dollar return. The point is that you could. © 2013 McGraw-Hill Ryerson Limited

Example 2 – Calculating Returns LO1 You bought a stock for $35 You received dividends of $1.25 The stock is now selling for $40 What is your dollar return? What is your percentage return? You might want to point out that total percentage return is also equal to total dollar return / beginning price. Total percentage return = 6.25 / 35 = 17.86% © 2013 McGraw-Hill Ryerson Limited

Example 2 – Calculating Returns (continued) LO1 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% Percentage return = 3.57% + 14.29% = 17.86% You might want to point out that total percentage return is also equal to total dollar return / beginning price. Total percentage return = 6.25 / 35 = 17.86% © 2013 McGraw-Hill Ryerson Limited

The Importance of Financial Markets 12.2 LO2 & LO3 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. © 2013 McGraw-Hill Ryerson Limited

© 2013 McGraw-Hill Ryerson Limited Figure 12.4 – If you invested $1 in 1957, how much would you have in 2011? LO2 Figure12-4 Point out that the scale on the vertical axis of this chart is not linear, and therefore the differences are greater than they appear. © 2013 McGraw-Hill Ryerson Limited

Table 12.2 Average Returns 1957 – 2011 LO2 © 2013 McGraw-Hill Ryerson Limited

© 2013 McGraw-Hill Ryerson Limited Risk Premiums LO3 The “extra” return earned for taking on risk Treasury bills are viewed as being risk-free The risk premium is the return over and above the risk-free rate © 2013 McGraw-Hill Ryerson Limited

Table 12.3 Average Returns and Risk Premiums 1957 – 2011 LO2 & LO3 © 2013 McGraw-Hill Ryerson Limited

Variance and Standard Deviation 12.4 LO3 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. © 2013 McGraw-Hill Ryerson Limited

Example – Variance and Standard Deviation LO3 Year Actual Return Average Return Deviation from the Mean Squared Deviation 1 .15 .105 .045 .002025 2 .09 -.015 .000225 3 .06 -.045 4 .12 .015 Totals .42 .00 .0045 Remind students that the variance for a sample is computed by dividing by the number of observations – 1. The standard deviation is just the square root. Variance = .0045 / (4 - 1) = .0015 Standard Deviation = .03873 © 2013 McGraw-Hill Ryerson Limited

Table 12.4 Historical Returns and Standard Deviations 1957 – 2011 LO3 © 2013 McGraw-Hill Ryerson Limited

© 2013 McGraw-Hill Ryerson Limited Figure 12.6 – Normal Distribution and a Portfolio of Large Common Stocks LO3 © 2013 McGraw-Hill Ryerson Limited

© 2013 McGraw-Hill Ryerson Limited Figure 12.5 – Frequency distribution of Returns on Canadian Common Stocks LO2 © 2013 McGraw-Hill Ryerson Limited

More on Average Returns 12.5 LO1 There are many different ways of calculating returns over multiple periods Two methods are: Arithmetic Average Return Geometric Average Return Arithmetic average is a better forward-looking measure of average expected future return. The arithmetic average could be used to give an indication as to what future returns would be on a stock. Geometric average is a better historical measure of average expected return, as it takes into account the effects of compounding. It could be used to show how an investment portfolio increased in value over a period of time. © 2013 McGraw-Hill Ryerson Limited

Arithmetic vs. Geometric Average Example LO1 Invested $100 in a stock five years ago Yr. returns: 15%, -8%, 12%, 18% & -11% What is your arithmetic ave. rate of return? What is your investment worth today? What is your geometric ave. return? © 2013 McGraw-Hill Ryerson Limited

Calculating Arithmetic Average LO1 The return in an average year was 5.2%. © 2013 McGraw-Hill Ryerson Limited

What is the investment worth today? LO1 FV=$100(1+.15)(1-.08)(1+.12)(1+.18)(1-.11) FV=$124.44 © 2013 McGraw-Hill Ryerson Limited

Calculating Geometric Average LO1 What equivalent rate of return would you have to earn every year on average to achieve this same future wealth? Your geometric or compound return was 4.47% each year. Notice that this is lower than the arithmetic average. This ALWAYS holds EXCEPT when the returns are the SAME every period. © 2013 McGraw-Hill Ryerson Limited

© 2013 McGraw-Hill Ryerson Limited Geometric Average LO1 The general formula for calculating the geometric average return is the following: © 2013 McGraw-Hill Ryerson Limited

Geometric vs. Arithmetic Average: Two Numerical Examples LO1 Example 1: $100 investment Year 1 return = 100% & Year 2 return = – 50% Arithmetic ave = (100% - 50%) / 2 = + 25% Geo. ave. = [(1 + 1)(1 - .5)]1/2 – 1 = 0% The geometric return is more reflective of what one will have after 2 years. You double your money in year 1 to $200. Then in year 2, you lose ½ of the $200 to wind up with $100. After 2 years, you are right back where you started! That is, you have earned NO return on your investment. © 2013 McGraw-Hill Ryerson Limited

Geometric vs. Arithmetic Average: Two Numerical Examples (cont.) LO1 Example 2: $100 investment Year 1 return = 10% & Year 2 return = 10% Arithmetic ave = (10% + 10%) / 2 = + 10% Geo. ave. = [(1 + .10)(1 + .10)]1/2 – 1 = + 10% Note that when the return is the SAME every period, then the arithmetic average and the geometric average are the SAME and simply equal to the return that is being earned every period. If there is any variation in return from period to period, than the arithmetic return will exceed the geometric return. © 2013 McGraw-Hill Ryerson Limited

Geometric vs. Arithmetic Average Returns 1957-2011 LO1 © 2013 McGraw-Hill Ryerson Limited

Capital Market Efficiency 12.6 LO4 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 © 2013 McGraw-Hill Ryerson Limited

Figure 12.7 – Reaction to New Information LO4 © 2013 McGraw-Hill Ryerson Limited

What Makes Markets Efficient? LO4 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 Point out that one consequence of the wider availability of information and lower transaction costs is that the market will be more volatile. It is easier to trade on “small” news instead of just big events. It is also important to remember that not all available information is reliable information. It’s important to still do the research and not just jump on everything that crosses the news wire. © 2013 McGraw-Hill Ryerson Limited

Common Misconceptions about EMH LO4 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! © 2013 McGraw-Hill Ryerson Limited

Strong Form Efficiency LO4 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. Students are often very interested in insider trading. This could be a good discussion point. © 2013 McGraw-Hill Ryerson Limited

Semistrong Form Efficiency LO4 Prices reflect ALL PUBLICLY available information including trading information, annual reports, press releases, etc. If the market is semistrong form efficient, then investors can NOT earn ABNORMAL returns by trading on PUBLIC information. Implies that fundamental analysis will NOT lead to ABNORMAL returns. Empirical evidence suggests that some stocks are semistrong form efficient, but not all. Larger, more closely followed stocks are more likely to be semistrong form efficient. Small, more thinly traded stocks may not be semistrong form efficient but liquidity costs may wipe out any abnormal returns that are available. © 2013 McGraw-Hill Ryerson Limited

© 2013 McGraw-Hill Ryerson Limited Weak Form Efficiency LO4 Prices reflect ALL past MARKET information such as PRICE and VOLUME. If the market is weak form efficient, then investors can NOT 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. Emphasize that just because technical analysis shouldn’t lead to abnormal returns, that doesn’t mean that you won’t earn fair returns using it – efficient markets imply that you will. You might also want to point out that there are many technical trading rules that have never been empirically tested; so it is possible that one of them might lead to abnormal returns. But if it is well publicized, then any abnormal returns that were available will soon evaporate. © 2013 McGraw-Hill Ryerson Limited

© 2013 McGraw-Hill Ryerson Limited 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 the difference between an arithmetic and a geometric average? What is capital market efficiency? What are the three forms of market efficiency? © 2013 McGraw-Hill Ryerson Limited

© 2013 McGraw-Hill Ryerson Limited Summary 12.7 You should know that: Risky assets earn a risk premium. Greater risk requires a larger required reward. In an efficient market, prices adjust quickly and correctly to new information. The three levels of market efficiency are strong form efficient, semistrong form efficient, and weak form efficient. © 2013 McGraw-Hill Ryerson Limited

© 2014 Dr. William F. Rentz & Associates Additions, deletions, and corrections to these transparencies were performed by Dr. William F. Rentz solely for use at the University of Ottawa. The above copyright notice applies to all changes made herein.