Capital Markets 1 Risk and Return: Historical Perspective Historical Returns Market Efficiency

Capital Markets 2 Historical Returns Average returns  Arithmetic versus geometric Risk premium =  Return – risk-free return  Compensation for taking risk Standard deviation  Measures variability of returns  Two-thirds of the time returns should fall:

Capital Markets 3 Expected Return Stock AStock B ProbabilityReturnProbabilityReturn 10%-15%-1.5%20%-50%-10% 40%10%4%30%0% 50%25%12.5%50% 25% Expected Return15%Expected Return15% Can Stock B have the same Expected Return as Stock A???

Capital Markets 4 Historical Returns Investment Average Return Risk Premium Standard Deviation Large cap stocks 11.7%7.9%20.6% Small cap stocks16.4%12.6%33.0% Long-term corporate bonds5.9%2.1%8.4% Treasury bills (Risk-free rate of return)3.8%0.0%3.1% Inflation3.1%4.2% 10/15/99 Wall Street Journal, equity risk premium has fallen from 10% in early 1980s to 2% in recent months…

Capital Markets 5 Unusual returns S&P 500 Annual Return  1995: 37.6%  1996: 23.0%  1997: 33.4%  1998: 28.6%  1999: 21.9%

Capital Markets 6 Time In Market One Year25 Years Return High52.3%High10.2% Average11.4%Average8.9% Low (2008…)-37.0%Low7.9%

Capital Markets 7 Implications Correlation of risk and reward  To achieve above average returns, you must take risk This can be done in an intelligent fashion!!!  Knowing your risk tolerance  Time horizon: how long until I need this money?  Diversification

Capital Markets 8 Time in Market Investing for long-periods of time, likely you will have positive returns Investing for long-period of time reduces risk.  Time in market, not timing market is your goal.  In the short-run, anything can happen

Capital Markets 9 Reducing Risk While Obtaining Returns Diversify Invest for long-term

Capital Markets 10 Forms of market efficiency Strong: all information is reflected in stock prices  Including public and private information  No one can outperform the market What about Martha?  Use of index funds Diversification Efficiency  Underperformance by investors Average return large cap: Average return large cap mutual fund:  Expenses: management fees/trading costs Average return large cap mutual fund investor:  Buying last period’s top performer

Capital Markets 11 Forms of market efficiency Semi-strong: all publicly available information is reflected in stock prices  Corporate financial analysis is a waste of time Stock prices only react to “new” information differing from expectations  Questions: Assumes intelligent investors?  Valid assumption?  Decline in inventory turnover ratio??? Assumes rational investors?  Valid assumption?

Capital Markets 12 Forms of market efficiency Weak: all prior stock price patterns reflected in stock prices  Technical analysis is a waste of time  Question… January effect…anomaly??  Sell losers, deduct losses up to $3,000  Hold winners, pay not tax until you sell