1. T12.1 Chapter Outline Chapter 12 Some Lessons from Capital Market History Chapter Organization 12.1Returns 12.2The Historical Record 12.3Average Returns: The First Lesson 12.4The Variability of Returns: The Second Lesson 12.5Capital Market Efficiency 12.6Summary and Conclusions Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 CLICK MOUSE OR HIT SPACEBAR TO ADVANCE

2. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T12.2 Risk, Return, and Financial Markets “... Wall Street shapes Main Street. Financial markets transform factories, department stores, banking assets, film companies, machinery, soft-drink bottlers, and power lines from parts of the production process... into something easily convertible into money. Financial markets... not only make a hard asset liquid, they price that asset so as to promote it most productive use.” Peter Bernstein, in his book, Capital Ideas

3. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T12.3 Percentage Returns (Figure 12.2) Inflows Outflows $42.18 $1.85 $40.33 Total Dividends Ending market value t = 1 t – $37 Time

4. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T12.3 Percentage Returns (Figure 12.2) (concluded) Dividends paid atChange in market end of periodvalue over period Percentage return = Beginning market value Dividends paid atMarket value end of periodat end of period 1 + Percentage return = Beginning market value + +

5. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T12.4 Five Largest One-Day Percentage Declines in the Dow-Jones Industrial Average The Five Worst Days DatePoint Loss% Loss October 19, 1987 508.00 22.6% October 28, 1929 38.88 12.8 October 29, 1929 30.57 11.7 November 6, 1929 25.55 9.9 December 18, 1899 5.57 8.7 Source: The Wall Street Journal, Dow-Jones, Inc. All rights reserved.

6. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T12.5 Average Annual Returns, 1948-97 (Table 12.2) InvestmentAverage Return Canadian common stocks13.13% U.S. Common stocks (Cdn $)15.18 Long bonds7.81 Treasury bills6.09 Small stocks15.76 Inflation4.34

7. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T12.6 Average Annual Returns and Risk Premiums: 1948-1997 (Table 12.3) Investment Average Return Risk Premium Canadian common stocks13.13% 8.9% U.S. common stocks (Cdn $)15.18 9.09 Long bonds7.81 1.72 Small stocks*15.76 9.67 Inflation4.34 -1.75 Treasury bills6.09 0.0 *Average return for small stocks is based on data from 1970 to 1997.

8. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T12.7 Historical returns and standard deviations; 1948-97 (Table 12.4) Investment Avg. Return Standard Deviation Canadian common stocks13.13%16.45% U.S. common stocks (Cdn $)15.1816.73 Long bonds7.8110.47 Small stocks*15.7623.25 Inflation4.343.50 Treasury bills6.094.07  

9. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T12.8 The Normal Distribution (Figure 12.6) Probability Return on large company stocks 68% 95% > 99% – 3 – -36.22% – 2 – -19.77% – 1 – -3.32% 0 13.13% + 1 29.58% + 2 46.03% + 3 62.47%

10. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T12.9 Two Views on Market Efficiency “... in price movements... the sum of every scrap of knowledge available to Wall Street is reflected as far as the clearest vision in Wall Street can see.” Charles Dow, founder of Dow-Jones, Inc. and first editor of The Wall Street Journal (1903) “In an efficient market, prices ‘fully reflect’ available information.” Professor Eugene Fama, financial economist (1976)

11. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T12.10 Reaction of Stock Price to New Information in Efficient and Inefficient Markets (Figure 12.7) 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; 8 days elapse before the price completely reflects the new information Overreaction: The price overadjusts to the new information; it “overshoots” the new price and subsequently corrects. Price ($) Days relative to announcement day –8–6 –4–20+2 +4+6 +7 220 180 140 100 Overreaction and correction Delayed reaction Efficient market reaction

12. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T12.11 Chapter 12 Quick Quiz 1. How are average annual returns measured? 2. How is volatility measured? Assume your portfolio has had returns of 10%, -7%, 28%, and -11% over the last four years. What is the average annual return? Your average annual return is simply: [.10 + (-.07) +.28 + (-.11)]/4 = ________% per year

13. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T12.11 Chapter 12 Quick Quiz (continued) Return Volatility: The usual measure of volatility is the standard deviation, which is the square root of the ________: YearActualAverageReturnSquared returnreturndeviationdeviation 1.10.05.05.0025 2-.07.05-.12.0144 3.28.05.23.0529 4 -0.11.05-.16.0256 Total.20.00.0954 The variance, 2 or Var(R) =.0954/(________) =.0318 The standard deviation, or SD(R) = =.1783 or 17.83%.0318

14. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T12.11 Chapter 12 Quick Quiz (continued) Now let’s use our knowledge of capital market history to make some financial decisions.  Suppose the current T-bill rate is 5%. An investment has “average” risk relative to a typical share of stock. It offers a 10% return. Is this a good investment?  Suppose an investment is similar to buying small company equities. If the T-bill rate is 5%, what return would you demand?

15. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T12.11 Chapter 12 Quick Quiz (concluded) Risk premiums: The risk premium is the difference between a risky investment’s return and a riskless return. Based on historical data: InvestmentAverageStandardRisk returndeviationpremium Common12.7%20.3%____% stocks Small17.7%34.1%____% stocks LT Corporates6.0%8.7%____% Long bonds5.4%9.2%____% Treasury bills3.8%3.3%____%

16. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T12.12 Solution to Problem 12.3 Suppose a stock had an initial price of $62 per share, paid a dividend of $1.25 per share during the year, and had an ending price of $72. Calculate: a.percentage total return b.dividend yield c.capital gains yield

17. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T12.12 Solution to Problem 12.3 (concluded) a.percentage total return = R = [$1.25 + ($72 - 62)]/$62 = 18.1% b.dividend yield = $1.25/$62 =.02 = 2% c.capital gains yield = ($72 - 62)/$62 =.161 = 16.1%

18. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T12.13 Solution to Problem 12.12 Using the following returns, calculate the average returns, the variances, and the standard deviations for stocks X and Y. Returns YearXY 1 18% 26% 2 6 -7 3-9-20 413 31 5 7 16

19. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc. 1999 T12.13 Solution to Problem 12.12 (concluded) Mean return on X = (.18 +.06 -.09 +.13 +.07)/5 = _____. Mean return on Y = (.26 -.07 -.20 +.31 +.16)/5 = _____. Variance of X = [(.18-.07) 2 + (.06-.07) 2 - (0.09-.07) 2 + (.13-.07) 2 + (.07-.07) 2 ]/(5 - 1) =.01035. Variance of Y = [(.26-.092) 2 + (-.07-.092) 2 - (-.20-.092) 2 + (.31-.092) 2 + (.16-.092) 2 ]/(5 - 1) =.04797. Standard deviation of X =(_______) 1/2 = _______%. Standard deviation of Y =(.04797) 1/2 = 21.90%.