Chapter 10

Risk and Return: Lessons from Market History

 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

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10-1
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

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10-2
 Dollar Returns
the sum of the cash received and Dividends
the change in value of the asset,
in dollars.
Ending
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.

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10-3
Dollar Return = Dividend + Change in Market Value
dollar return
percentage return 
beginning market value

dividend  change in market value


beginning market value

 dividend yield  capital gains yield

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 Suppose you bought 100 shares of XYZ Co. 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
7.3% =
$4,500
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  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 )  L  (1 RT ) 1


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10-6
 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%

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 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

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10-8
  The history of capital market returns can be
summarized by describing the:
◦ average return (R1 L  RT )
R
T
◦ the standard deviation of those returns
(R1  R)  (R2  R) L (RT  R)
2 2 2
SD  VAR 
 T 1
◦ the frequency distribution of the returns

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10-9
 Average Standard
Series Annual Return Deviation Distribution

Large Company Stocks 12.1% 20.1%

Small Company Stocks 16.7 32.1

Long-Term Corporate Bonds 6.4 8.4

Long-Term Government Bonds 6.1 10.0

U.S. Treasury Bills 3.5 3.1

Inflation 3.0 4.1

– 90% 0% + 90%

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10-10
 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 2014 was:
8.6% = 12.1% – 3.5%
◦ The average excess return from small company common stocks for
the period 1926 through 2014 was:
13.2% = 16.7% – 3.5%
◦ The average excess return from long-term corporate bonds for the
period 1926 through 2014 was:
2.6% = 6.1% – 3.5%

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 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
2014 was 13.2%.
 Given a risk-free rate of 2%, we have an expected
return on the market of small-company stocks of
15.2% = 13.2% + 2%

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10-12
 18%

16%
Small-Company Stocks
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

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10-13
 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.

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10-14
 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 20.1 percent of the
mean of 12.1 percent will be
approximately 2/3.

– 3s – 2s – 1s 0 + 1s + 2s + 3s
– 48.2% – 28.1% – 8.0% 12.1% 32.2% 52.3% 72.4% Return on
large company common
68.26% stocks
95.44%

99.74%
10-15
 The 20.1% standard deviation we found for large
stock returns from 1926 through 2014 can now be
interpreted in the following way:
◦ If stock returns are approximately normally distributed, the
probability that a yearly return will fall within 20.1 percent
of the mean of 12.1% will be approximately 2/3.

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10-16
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

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10-17
 The characteristics of individual securities that are of
interest are the:
◦ Expected Return
◦ Variance and Standard Deviation
◦ Covariance and Correlation (to another security or index)

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10-18
Consider the following two risky asset world. There
is a 1/3 chance of each state of the economy, and
the only assets are a stock fund and a bond fund.

Rate of Return
Scenario Probability Stock Fund Bond Fund
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%

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10-19
 Stock Fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

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10-20
 Stock Fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

E(rS )  1 3  (7%)  1 3  (12%)  1 3  (28%)

E(rS )  11%
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10-21
 Stock Fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

(7% 11%)  .0324 2

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10-22
 Stock Fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

1
.0205  (.0324  .0001 .0289)
3
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10-23
 Stock Fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

14.3%  0.0205
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10-24
 Stock Bond
Scenario Deviation Deviation Product Weighted
Recession -18% 10% -0.0180 -0.0060
Normal 1% 0% 0.0000 0.0000
Boom 17% -10% -0.0170 -0.0057
Sum -0.0117
Covariance -0.0117

“Deviation” compares return in each state to the expected return.

“Weighted” takes the product of the deviations multiplied by the
probability of that state.

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10-25
 Cov(a,b)

s as b
.0117
  0.998
(.143)(.082)

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10-26
 Stock Fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

Note that stocks have a higher expected return than bonds

and higher risk. Let us turn now to the risk-return tradeoff
of a portfolio that is 50% invested in bonds and 50%
invested in stocks.

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10-27
 Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

The rate of return on the portfolio is a weighted average of

the returns on the stocks and bonds in the portfolio:
rP  w B rB  w S rS
5 %  50 %  (  7 %)  50 %  (17 %)
10-28
 Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%
The expected rate of return on the portfolio is a weighted
average of the expected returns on the securities in the
portfolio.
E (rP )  w B E (rB )  w S E (rS )

9%  50%  (11%)  50%  (7%)

10-29
 Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

The variance of the rate of return on the two risky assets

portfolio is
?  (w B?B )  (w S?S )  2(w B?B )(w S?S )?BS
2
P
2 2

where BS is the correlation coefficient between the returns

on the stock and bond funds.

 10-30
 Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

Observe the decrease in risk that diversification offers.

An equally weighted portfolio (50% in stocks and 50%
in bonds) has less risk than either stocks or bonds held
in isolation. This is not always the case.

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10-31
 Diversification can substantially reduce the variability
of returns without an equivalent reduction in expected
returns.
 This reduction in risk arises because worse than
expected returns from one asset are offset by better
than expected returns from another.
 However, there is a minimum level of risk that cannot
be diversified away, and that is the systematic
portion.

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10-32
 In a large portfolio the variance terms are
s effectively diversified away, but the covariance
terms are not.
Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
n
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10-33
 A systematic risk is any risk that affects a large number of
assets, each to a greater or lesser degree.
 An unsystematic risk is a risk that specifically affects a single
asset or small group of assets.
 Unsystematic risk can be diversified away.
 Examples of systematic risk include uncertainty about general
economic conditions, such as GNP, interest rates or inflation.
 On the other hand, announcements specific to a single
company are examples of unsystematic risk.

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10-34
 Total risk = systematic risk + unsystematic risk
 The standard deviation of returns is a measure of total
risk.
 For well-diversified portfolios, unsystematic risk is
very small.
 Consequently, the total risk for a diversified portfolio
is essentially equivalent to the systematic risk.

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10-35