Dollar
Returns
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The total dollar return on an investment is equal
to the dollar income plus the dollar gain (or loss) from any change in
its price. For a share of common stock, the total
dollar return (KEY TERM) = _____ + _____ .
Percentage
Returns
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Percentage returns are found by dividing the
dollar return by initial price of the investment. Specifically, the percentage
return on common stock is equal to _____
+ _____ (KEY TERM). One year ago you purchased Ford
Motor Company common stock at $48 per share. You have collected
a dividend of 50 cents per share, and expect to sell the stock this afternoon
for $25.12 per share. What is your total return for the period? CONCEPT CHECK
The
Historical Record
A
First Look Historical evidence indicates
a positive relationship between return and risk in the financial markets.
We rank the following asset classes in descending order of return and risk:
(1) small-firm common stocks, (2) large-firm common stocks, (3) long-term
corporate bonds, (4) long-term government bonds, and (5) U.S. Treasury
bills. Not surprisingly, the greatest
return over the period 1926-1999
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has been associated with the
greatest risk.
A
Closer Look It should also be noted that year-to-year returns are quite
variable both within asset classes and across asset classes.
Calculating
Average Returns To compute the average return from historical data,
one simply sums the returns and divides by the number of observations.
In other words, an arithmetic, or simple average.
Average
Returns: The Historical Record: Based on the information in the text,
what was the average annual return on large-firm common stocks over the
period l926-1999? What was the average annual return on long-term government
bonds over the same period? Why is the former larger than the latter? CONCEPT CHECK
Risk
Premiums
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The historical evidence
suggests that the returns on higher-risk assets has, on average, exceeded
that on lower-risk assets. The additional return observed on the latter
is called a risk
premium (KEY TERM). What is the risk premium on US Treasury bills? (Hint:
See Table
10.3
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.) CONCEPT CHECK
The
First Lesson Over the 1926-99 period, risky assets, on average,
have earned a risk premium.
The
Variability of Returns: The Second Lesson
Frequency
Distributions and Variability People often wonder what one might expect
to return on a portfolio of common stocks in a given year. Although it
is not possible to predict common stock returns, it is possible to draw
a frequency distribution of historical returns. Figure
10.9
(60.0K)
is such a distribution, and suggests that year-to-year
returns most often fall in the range from -10 to + 40 percent annually.
The
Historical Variance and Standard Deviation Variance
(KEY TERM) and standard
deviation (KEY TERM) are statistical measures of the dispersion of a variable
around its mean value. You observed annual returns of 23%, -1l%, and 17%
on XYZ.com common stock over the last three years. Compute the average
return, the variance of returns, and the standard deviation of returns
over the period. Would the math still work if all three of the returns
had been negative? CONCEPT CHECK
The
Historical Record Actual
return distributions
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bear out our earlier contention about
the relationship between return and risk in the financial markets: greater
average returns are generally associated with greater variability of return.
Normal
Distribution Statistical theory tells us that, given a normal distribution,
approximately 2/3 of the area under the curve falls within +/- 1 standard
deviation of the mean, and about 95 percent of the area falls within +/-
2 standard deviations of the mean. If we assume that returns on common
stocks are roughly normally distributed, we can get a better idea of the
likelihood of a given outcome. Over the 1926-99 period, the average annual
return on large-company common stocks was 13.3%, and the standard deviation
of returns was 20.1%. Based on the historical distribution, what is the
probability that the return on this portfolio will be between 33.4% and
- 6.8%? CONCEPT CHECK
The
Second Lesson On average, bearing risk is handsomely rewarded, but
in a given year there is a significant chance of a dramatic change in value.
Using
Capital Market History Now that we know something of historical returns
and their variability, we can use that information in evaluating investment
opportunities. Additionally, the evidence suggests that discussing return
without also discussing risk, is a meaningless (and sometimes misleading!)
exercise.
Price
Behavior in an Efficient Market In an efficient market, securities
prices rapidly adjust to reflect new information. How might prices behave
in an inefficient
market
(66.0K)
?
The
Efficient Markets Hypothesis Investments in securities that are traded
in an efficient market will, on average, have a NPV of zero. Market efficiency
is largely the result of many investors actively seeking out information
about a security, then using that information to buy or sell.
Some
Common Misconceptions about the EMH
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The bottom line: In
an efficient market, the price a firm will obtain when it sells a share
of its stock is a "fair" price in the sense that it reflects
the value of that stock given the information available about the firm.
The
Forms of Market Efficiency The degree of efficiency of a given market
is a function of what information is reflected in market prices. In a strong-form
(53.0K)
efficient market, prices reflect all information, both public
and private, about an asset. In a semistrong-form
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efficient market, prices reflect only publicly available information
about an asset. And in a market that is only weak-form
efficient
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, the current market price of a stock reflects its
own past prices.
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