Chapter 10

Risk and Return: Lessons from Market History

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Key Concepts and Skills
 Know how to calculate the return on an
investment
 Know how to calculate the standard deviation of
an investment’s returns
 Understand the historical returns and risks on
various types of investments
 Understand the importance of the normal
distribution
 Understand the difference between arithmetic and
geometric average returns 10-1
Chapter Outline
10.1 Returns
10.2 Holding-Period Returns
10.3 Return Statistics
10.4 Average Stock Returns and Risk-Free
Returns
10.5 Risk Statistics
10.6 More on Average Returns
10.7 The U.S. Equity Risk Premium: Historical
and International Perspectives
10-2
10.1 Returns
 Dollar Returns Dividends
the sum of the cash received
and the change in value of the Ending
asset, in dollars. market value

Time 0 1
Percentage Returns
–the sum of the cash received and the
Initial change in value of the asset, divided
investment by the initial investment.

10-3
Returns
Dollar Return = Dividend + Change in Market Value
dollar return
percentage return =
beginning market val ue

dividend + change in market val ue

=
beginning market val ue

= dividend yield + capital gains yield

10-4
Returns: Example
 Suppose you bought 100 shares of Wal-Mart (WMT) one
year ago today at $45. Over the last year, you received $27
in dividends (27 cents per share × 100 shares). At the end of
the year, the stock sells for $48. How did you do?
 You invested $45 × 100 = $4,500. At the end of the year,
you have stock worth $4,800 and cash dividends of $27.
Your dollar gain was $327 = $27 + ($4,800 – $4,500).
 Your percentage gain for the year is:

$327
7.27% =
$4,500
 Dividend yield = 27/4,500 = 0.6%
 Capital gain yield = 300/4,500 = 6.67%
10-5
Returns: Example
Dollar Return: $27
$327 gain
$300

Time 0 1
Percentage Return:

$327
-$4,500 7.3% =
$4,500
10-6
10.2 Holding Period Return
 The holding period return is the return
that an investor would get when holding
an investment over a period of T years,
when the return during year i is given as
Ri:
HPR = (1 + R1 )  (1 + R2 )    (1 + RT ) − 1

10-7
Holding Period Return: Example
 Suppose your investment provides the
following returns over a four-year
period:

Year Return Your holding period return =

1 10%
= (1 + R1 )  (1 + R2 )  (1 + R3 )  (1 + R4 ) − 1
2 -5%
3 20% = (1.10)  (.95)  (1.20)  (1.15) − 1
4 15% = .4421 = 44.21%
10-8
Historical Returns
 A famous set of studies dealing with rates of returns
on common stocks, bonds, and Treasury bills was
conducted by Roger Ibbotson and Rex Sinquefield.
 They present year-by-year historical rates of return
starting in 1926 for the following five important
types of financial instruments in the United States:
◼ Large-company Common Stocks
◼ Small-company Common Stocks
◼ Long-term Corporate Bonds
◼ Long-term U.S. Government Bonds
◼ U.S. Treasury Bills 10-9
10.3 Return Statistics
 The history of capital market returns can be
summarized by describing the:
◼ average return
( R1 +  + RT )
R=
T
◼ the standard deviation of those returns

( R1 − R ) 2 + ( R2 − R ) 2 +  ( RT − R ) 2
SD = VAR =
T −1
◼ the frequency distribution of the returns
10-10
Historical Returns, 1926-2007
Average Standard
Series Annual Return Deviation Distribution

Large Company Stocks 12.3% 20.0%

Small Company Stocks 17.1 32.6

Long-Term Corporate Bonds 6.2 8.4

Long-Term Government Bonds 5.8 9.2

U.S. Treasury Bills 3.8 3.1

Inflation 3.1 4.2

– 90% 0% + 90%

Source: © Stocks, Bonds, Bills, and Inflation 2008 Yearbook , Ibbotson Associates, Inc., Chicago (annually updates work by
Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.
10-11
10.4 Average Stock Returns and Risk-Free Returns
 The Risk Premium is the added return (over and above
the risk-free rate) resulting from bearing risk.
 One of the most significant observations of stock market
data is the long-run excess of stock return over the risk-
free return.
◼ The average excess return from large company common
stocks for the period 1926 through 2007 was:
8.5% = 12.3% – 3.8%
◼ The average excess return from small company common
stocks for the period 1926 through 2007 was:
13.3% = 17.1% – 3.8%
◼ The average excess return from long-term corporate bonds
for the period 1926 through 2007 was:
2.4% = 6.2% – 3.8% 10-12
Risk Premiums
 Suppose that The Wall Street Journal announced that
the current rate for one-year Treasury bills is 2%.
 What is the expected return on the market of small-
company stocks?
 Recall that the average excess return on small
company common stocks for the period 1926
through 2007 was 13.3%.
 Given a risk-free rate of 2%, we have an expected
return on the market of small-company stocks of
15.3% = 13.3% + 2%
10-13
The Risk-Return Tradeoff
18%
Small-Company Stocks
16%
Annual Return Average

14%

12% Large-Company Stocks

10%

8%

6%
T-Bonds
4%
T-Bills
2%
0% 5% 10% 15% 20% 25% 30% 35%
Annual Return Standard Deviation

10-14
10.5 Risk Statistics
 There is no universally agreed-upon
definition of risk.
 The measures of risk that we discuss are
variance and standard deviation.
◼ The standard deviation is the standard statistical
measure of the spread of a sample, and it will be
the measure we use most of this time.
◼ Its interpretation is facilitated by a discussion of
the normal distribution.
10-15
Normal Distribution
 A large enough sample drawn from a normal
distribution looks like a bell-shaped curve.
Probability

The probability that a yearly return

will fall within 20.0 percent of the
mean of 12.3 percent will be
approximately 2/3.

– 3 – 2 – 1 0 + 1 + 2 + 3
– 47.7% – 27.7% – 7.7% 12.3% 32.3% 52.3% 72.3% Return on
large company common
68.26% stocks
95.44%

99.74% 10-16
Normal Distribution
 The 20.0% standard deviation we found
for large stock returns from 1926
through 2007 can now be interpreted in
the following way:
◼ If stock returns are approximately normally
distributed, the probability that a yearly
return will fall within 20.0 percent of the
mean of 12.3% will be approximately 2/3.
10-17
Example – Return and Variance
Year Actual Average Deviation from the Squared
Return Return Mean Deviation
1 .15 .105 .045 .002025

2 .09 .105 -.015 .000225

3 .06 .105 -.045 .002025

4 .12 .105 .015 .000225

Totals .00 .0045

Variance = .0045 / (4-1) = .0015 Standard Deviation = .03873

10-18
10.6 More on Average Returns
 Arithmetic average – return earned in an average
period over multiple periods
 Geometric average – average compound return per
period over multiple periods
 The geometric average will be less than the arithmetic
average unless all the returns are equal.
 Which is better?
◼ The arithmetic average is overly optimistic for long
horizons.
◼ The geometric average is overly pessimistic for short
horizons.
10-19
Geometric Return: Example
 Recall our earlier example:
Year Return Geometric average return =
1 10% (1 + Rg ) 4 = (1 + R1 )  (1 + R2 )  (1 + R3 )  (1 + R4 )
2 -5%
3 20% Rg = 4 (1.10)  (.95)  (1.20)  (1.15) − 1
4 15% = .095844 = 9.58%
So, our investor made an average of 9.58% per year,
realizing a holding period return of 44.21%.
1.4421 = (1.095844 ) 4
10-20
Geometric Return: Example
 Note that the geometric average is not
the same as the arithmetic average:
Year Return
R1 + R2 + R3 + R4
1 10% Arithmetic average return =
2 -5%
4
10% − 5% + 20% + 15%
3 20% = = 10%
4 15% 4

10-21
Perspectives on the Equity Risk Premium
 Over 1926-2007, the U.S. equity risk premium has
been quite large:
◼ Earlier years (beginning in 1802) provide a smaller
estimate at 5.4%
◼ Comparable data for 1900 to 2005 put the international
equity risk premium at an average of 7.1%, versus 7.4% in
the U.S.
 Going forward, an estimate of 7% seems reasonable,
although somewhat higher or lower numbers could
also be considered rational

10-22