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 10.1 Returns

4. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.3 Risk, Return and Financial Markets 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’s 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 10.2 The Historical Record

9. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.8 The Importance of Financial Markets “Financial Markets” allow companies, governments and individuals to increase their utility Savers: defer consumption, invest in financial assets, and earn a return to compensate them for doing so Borrowers: have better access to capital that is available so that they can invest in productive assets Financial markets also provide information about the returns that are required for various levels of risk

10. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.9 Figure 10.4 A $1 investment in different types of portfolios: 1926 – 99 Note: 1. Stocks produce a higher return  higher risk 2. Stocks are more volatile than bonds. 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 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%

12. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.11 Year-to-Year Total Returns Notice Volatility and Returns Large-Company Stock Returns Long-Term Government Bond Returns U.S. Treasury Bill Returns

13. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.12 10.3 Average Returns: The First Lesson

14. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.13 Calculating Average Returns Simply add up the yearly returns and divide by the number of observations The result is the historical average of the individual values. Example: If you add up the returns for the Large-Company Stocks in Table 10.1 (Pg 284) and divide by 74 (years) you will get 13.3%.

15. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.14 Table 10.2 (Pg 286) Average Returns (1926 – 99) As Calculated from Table 10.1 (Pg 284) Note how much larger the stock returns are than the bond returns! InvestmentAverage Return Large stocks13.3% Small Stocks17.6% Long-term Corporate Bonds5.9% Long-term Government Bonds5.5% U.S. Treasury Bills3.8% (Risk-free rate) Inflation (Consumer Price Index) 3.2%

16. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.15 Average Returns: The Historical Record The previous Average Returns Calculated are Nominal – have not been adjusted for inflation The average inflation rate (measured by the Consumer Price Index - CPI) was 3.2 percent per year over the 74-year span Table 10.1: Add up the CPI for the 74 years and divide by 74

17. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.16 Average Returns: The Historical Record The nominal return on U.S. Treasury Bills was 3.8 percent per year (excludes inflation ) Real Return = Nominal Return - Inflation Example: The Average “Real” Return on U.S. Treasury Bills was: 3.8% – 3.2% =.6%

18. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.17 Risk Premiums Risk Premium – is the excess return required from an investment in a risky asset over that required from a risk-free investment 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

19. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.18 Historical Risk Premiums 1926 - 1999 Simply subtract the Risk Free Rate of Return If the risk premium is the return over and above the risk-free rate: 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% Note how much larger the stock risk premiums are than the bond risk premiums!

20. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.19 The First Key Lesson: Risky assets, on average, earn a risk premium There is a reward for bearing risk

21. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.20 10.4 The Variability of Returns: The Second Lesson

22. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.21 Frequency Distribution Figure 10.9 (Page 288) The number of times the annual return on a large stock portfolio fell within each 10 percent range The height of 12 in the range 20 to 30% means that 12 of the 74 annual returns were in that range Notice that the most frequent returns are in the 10 to 20% range and the 30 to 40% range

23. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.22 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 (%)

24. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.23 Variance and Standard Deviation We want to measure the “spread” in returns How far the actual return deviates from the average in a typical year? A measure of how volatile the return is. Volatile – tendency to vary widely Variance and standard deviation are the most commonly used measure of volatility The greater the volatility the greater the uncertainty Variance = sum of squared deviations from the mean / (number of observations – 1) Standard deviation = the positive square root of the variance

25. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.24 Example:Variance and Standard Deviation (Pg. 290) Know This – Put on Formula Sheet! YearActual Return Average Return Deviation from the Mean (Average) Squared Deviation 1-.20.175-.375.140625 2.50.175.325.105625 3.30.175.125.015625 4.10.175-.075.005625 Totals.70 / 4 =.175.000.267500 Variance = sum of squared deviations from the mean / (number of observations – 1) =.26750 / (4-1) =.0892 Standard Deviation = the positive square root of the variance: =.2987

26. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.25 Variance and Standard Deviation The larger the variance, the more the actual returns tend to differ from the average return Variation about the mean (average) The larger the variance or standard deviation, the more spread out the returns will be

27. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.26 Figure 10.10 ( Pg 291) Historical average returns, standard deviations, and frequency distributions: 1926 – 99. Notice that the standard deviation for the small-stock portfolio is more than 10 times larger than the T-bill portfolio’s standard deviation. 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

28. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.27 Figure 10.11 – (Pg 291) The Normal Distribution (or bell curve) – a symmetric, bell-shaped statistical distribution that is completely defined by its mean and standard deviation. Here, Illustrated returns are based on the historical return and standard deviation for a portfolio of large common stocks. Assuming a normal distribution, with a 13.3% Average Return/Mean and a Standard Deviation of 20.1: The probability that the return w/b within 1 Standard Deviation is 68% The probability that the return w/b within 2 Standard Deviations is 95% The probability that the return w/b within 3 Standard Deviations is 99% -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%

29. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.28 The Second Key Lesson: The greater is the risk, the greater the potential reward from a risky investment On average, bearing risk is handsomely rewarded, but, in a given year, there is a significant chance of a dramatic change in value.

30. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.29 10.5 Capital Market Efficiency

31. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.30 Efficient Capital Markets Efficient Markets Hypothesis (EMH) – is the hypotheses that actual capital markets, such as the NYSE, are efficient (i.e. fairly priced). Efficient Capital Market - Security prices reflect all available information. Prices adjust quickly and correctly when new information arrives. 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

32. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.31 Chapter 10 #12 – The broken line and the dotted line illustrate paths that the stock price might take in an inefficient market -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.

33. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.32 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

34. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.33 Common Misconceptions about Efficient Markets Hypothesis (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

35. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.34 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

36. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.35 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

37. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.36 Weak Form Efficiency Prices reflect all past (historical) 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

38. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.37 Market Efficiency Recap In an efficient market, prices adjust quickly and correctly to new information Asset prices in efficient markets are rarely too high or too low. How efficient capital markets (such as the NYSE) are is a matter of debate At a minimum, they’re probably much more efficient than most real asset markets

39. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 10.38 Chapter 10 Suggested Homework & Test Review Questions and Problems (Pgs 301 – 303): 1, 2, 5, 7, 9, 10, 16, 18, 19, 20, 21 Know how to calculate: Dollar Returns (Dividends, Interest, Capital Gain) Percentage Returns: Dividend yield Capital gains yield Total percentage return Real Return and Risk Premium Average Return Variance Standard Deviation Know chapter theories, concepts, and definitions