Professional Documents
Culture Documents
Returns
The Historical Record
Average Returns: The First Lesson
The Variability of Returns: The Second Lesson
Capital Market Efficiency
Dividends paid at
+
end of period
Change in market
value over period
Percentage return =
Beginning market value
Dividends paid at
+
end of period
Market value
at end of period
1 + Percentage return =
Beginning market value
A9.
A10.
Treasury Bills
14
12
10
8
6
4
2
0
1925
1935
1945
1955
1965
1975
1985
1998
Feb
Mar
Apr
Jun
Jul
Aug
Sep
Oct
Nov
Dec
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
-1.00%
-2.00%
Average
return
Standard
deviation
Risk
premium
Common stocks
13.2%
20.3%
____%
Small stocks
17.4%
33.8%
____%
LT Corporates
6.1%
8.6%
____%
Long-term
Treasury bonds
5.7%
9.2%
____%
Treasury bills
3.8%
3.2%
____%
Average
return
Standard
deviation
Risk
premium
Common stocks
13.2%
20.3%
9.4%
Small stocks
17.4%
33.8%
13.6%
LT Corporates
6.1%
8.6%
2.3%
Long-term
Treasury bonds
5.7%
9.2%
1.9%
Treasury bills
3.8%
3.2%
0%
Investment
Average Return
Risk Premium
Large-company stocks
13.2%
9.4%
Small-company stocks
17.4
13.6
6.1
2.3
5.7
1.9
3.8
0.0
Source: Stocks, Bonds, Bills and Inflation 1998 Yearbook, Ibbotson Associates, Inc. Chicago (annually updates work by
Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved
A24. Stock Price Reaction to New Information in Efficient and Inefficient Markets
Price ($)
Overreaction and
correction
220
180
140
Delayed reaction
100
8 6 4 2
+2 +4 +6 +7
Days relative
to announcement day
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.
3. Assume your portfolio has had returns of 11%, -8%, 20%, and -10%
over the last four years. What is the average annual return?
3. Assume your portfolio has had returns of 11%, -8%, 20%, and
-10% over the last four years. What is the average annual return?
dividend of $1.25 per share during the year, and had an ending
price of $45. Compute the percentage total return.
dividend of $1.25 per share during the year, and had an ending
price of $75. Compute the percentage total return.
18%
11
-7
-9
- 20
13
33
16
28%
= (_______)1/2 = _______%.
Standard deviation of Y
= (_______)1/2 = _______%.
= (.0106)1/2 = 10.30%.
Standard deviation of Y
= (.05195)1/2 = 22.79%.
modern finance. It is not possible to make good (i.e., valuemaximizing) financial decisions unless one understands the
relationship between risk and return.
pi
Probability
of state i
Ri
Return in
state i
.25
-5%
.50
15%
.25
35%
State of Economy
(pi Ri)
i=1
-1.25%
i=2
7.50%
i=3
8.75%
Expected return
Stock L
(2)
(1)
Probability
State of
of State of
EconomyEconomy Occurs
Stock U
(3)
Rate of
Return
if State
(2) (3)
(4)
Product
Occurs
(5)
Rate of
Return
if State
(2) (5)
(6)
Product
Recession
.80
-.20
-.16
.30
.24
Boom
.20
.70
.14
.10
.02
E(RL) = -2%
E(RU) = 26%
pi
Probability
of state i
ri
Return in
state i
.25
-5%
.50
15%
.25
35%
State of Economy
i=1
.04.01
i=2
00
i=3
.04.01
Var(R) = .02
State of the
economy
Probability
of state
Return on
asset A
Return on
asset B
Boom
0.40
30%
-5%
Bust
0.60
-10%
25%
1.00
A. Expected returns
B. Variances
State of the
economy
Probability
of state
Return
on A
Return
on B
Return on
portfolio
Boom
0.40
30%
-5%
12.5%
Bust
0.60
-10%
25%
7.5%
1.00
A. E(RP)
Note:
E(RP)
BUT:
State of the
economy
Probability
of state
Return
on A
Return
on B
Return on
portfolio
Boom
0.40
30%
-5%
10%
Bust
0.60
-10%
25%
10%
1.00
A.
E(RP)
= 10%
B.
SD(RP) =
0%
Stock A returns
Portfolio returns:
50% A and 50% B
Stock B returns
0.05
0.05
0.04
0.04
0.04
0.03
0.03
0.03
0.02
0.02
0.02
0.01
0.01
0.01
-0.01
0.01
-0.02
-0.03
0.01
0.02
0.03
0.02
0.03
Key issues:
Types of surprises
1. Systematic or market risks
2. Unsystematic/unique/asset-specific risks
Big risks are scary when you cannot diversify them, especially
when they are expensive to unload; even the wealthiest families
hesitate before deciding which house to buy. Big risks are not
scary to investors who can diversify them; big risks are
interesting. No single loss will make anyone go broke . . . by
making diversification easy and inexpensive, financial markets
enhance the level of risk-taking in society.
Peter Bernstein, in his book, Capital Ideas
(1)
Number of Stocks
in Portfolio
(2)
Average Standard
Deviation of Annual
Portfolio Returns
( 3)
Ratio of Portfolio
Standard Deviation to
Standard Deviation
of a Single Stock
49.24%
1.00
10
23.93 0.49
50
20.20 0.41
100
19.69 0.40
300
19.34 0.39
500
19.27 0.39
1,000
19.21 0.39
These figures are from Table 1 in Meir Statman, How Many Stocks Make a Diversified Portfolio? Journal of Financial
and Quantitative Analysis 22 (September 1987), pp. 35364. They were derived from E. J. Elton and M. J. Gruber, Risk
Reduction and Portfolio Size: An Analytic Solution, Journal of Business 50 (October 1977), pp. 41537.
Beta
Company
Coefficient
American Electric Power
.65
Exxon
.80
IBM
.95
Wal-Mart
1.15
General Motors
1.05
Harley-Davidson
1.20
Papa Johns
1.45
America Online
1.65
Source: From Value Line Investment Survey, May 8, 1998.
Amount
Invested
Portfolio
Weights
Beta
(2)
(3)
(4)
(3) (4)
Haskell Mfg.
$ 6,000
50%
0.90
0.450
Cleaver, Inc.
4,000
33%
1.10
0.367
Rutherford Co.
2,000
17%
1.30
0.217
$12,000
100%
Stock
(1)
Portfolio
1.034
7.000.00
2575
9.750.30
5050
12.500.60
7525
15.250.90
1000
18.001.20
125-25
20.751.50
Portfolio
Return (%) Beta
Key issues:
correctly valued?
correctly valued?
Total risk - the variance (or the standard deviation) of an assets return.
1. Assume: the historic market risk premium has been about 8.5%.
The risk-free rate is currently 5%. GTX Corp. has a beta of .85.
What return should you expect from an investment in GTX?
E(RGTX) =
3. The ______ is the equation for the SML; the slope of the SML =
______ .
1. Assume: the historic market risk premium has been about 8.5%.
The risk-free rate is currently 5%. GTX Corp. has a beta of .85.
What return should you expect from an investment in GTX?
E(RGTX) =
A63. An Example
Consider the following information:
State of
Economy
Boom
0.350.14
0.150.33
Bust
0.650.12
0.03-0.06
Stock C
Return
three stocks?
What is the variance of a portfolio invested 15 percent each in A and B,
and 70 percent in C?
Bust:
b.
Boom:
Bust:
E[Rp]
so
2
p
= _____
b.
Boom:
Bust:
so
2
p
return on a portfolio that was equally invested in largecompany stocks and long-term government bonds.
What was the return on a portfolio that was equally invested in
1998 was 13.2 percent, and the average annual return on long-term
government bonds was 5.7 percent. So, the return on a portfolio with
half invested in common stocks and half in long-term government
bonds would have been:
E[Rp1] = .50(13.2) + .50(5.7) = 9.45%
If on the other hand, one would have invested in the common stocks of
small firms and in Treasury bills in equal amounts over the same period,
ones portfolio return would have been:
E[Rp2] = .50(17.4) + .50(3.8) = 10.6%.