1. 12 Lessons From Capital Market History Prepared by Anne Inglis
Edited by William Rentz

2. 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

3. © 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

4. 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

5. © 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

6. 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

7. 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 = or 6.32%
Capital gain = $25 / $950 = or 2.63%
Total percentage return = 6.32% % = 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

8. 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

9. Example 2 – Calculating Returns (continued)
LO1
What is your dollar return?
Dollar return = $ ($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% % = 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

10. 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

11. © 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

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

13. © 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

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

15. 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

16. Example – Variance and Standard Deviation
LO3
Year
Actual Return
Average Return
Deviation from the Mean
Squared Deviation 1
.15
.105
.045 2
.09
-.015 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 = / (4 - 1) = Standard Deviation =
© 2013 McGraw-Hill Ryerson Limited

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

18. © 2013 McGraw-Hill Ryerson Limited
Figure 12.6 – Normal Distribution and a Portfolio of Large Common Stocks
LO3
© 2013 McGraw-Hill Ryerson Limited

19. © 2013 McGraw-Hill Ryerson Limited
Figure 12.5 – Frequency distribution of Returns on Canadian Common Stocks
LO2
© 2013 McGraw-Hill Ryerson Limited

20. 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

21. 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

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

23. 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

24. 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

25. © 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

26. 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

27. 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. = [( )( )]1/2 – 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

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

29. 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

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

31. 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

32. 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

33. 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

34. 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

35. © 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

36. © 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

37. © 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

38. © 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.