Professional Documents
Culture Documents
1 A Brief History of
Risk and Return
1-2
Example I: Who Wants To Be A Millionaire?
• How? Suppose:
– You invest $300 per month.
– Your investments earn 9% per year.
– You decide to take advantage of deferring taxes on your investments.
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Example II: Who Wants To Be A Millionaire?
• Instead, suppose:
– You invest $500 per month.
– Your investments earn 12% per year.
– You decide to take advantage of deferring taxes on your investments.
• Realistic?
• $250 is about the size of a new car payment, and perhaps your employer will
kick in $250 per month
• Over the last 81 years, the S&P 500 Index return was about 12%
1-4
A Brief History of Risk and Return
• Our goal in this chapter is to see what financial market history can
tell us about risk and return.
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Dollar Returns
• Example:
1-6
Percent Returns
• The total percent return is the return for each dollar invested.
or
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Example: Calculating Total Dollar
and Total Percent Returns
1-8
Annualizing Returns, I.
• You buy 200 shares of Lowe’s Companies, Inc. at $48 per share.
Three months later, you sell these shares for $51 per share. You
received no dividends. What is your return? What is your annualized
return?
This return is
• Return: (Pt+1 – Pt) / Pt = ($51 - $48) / $48 known as the
holding period
= .0625 = 6.25%
percentage return.
1-9
Annualizing Returns, II
1-10
A $1 Investment in Different Types
of Portfolios, 1926—2006.
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Financial Market History
1-12
The Historical Record:
Total Returns on Large-Company Stocks.
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The Historical Record:
Total Returns on Small-Company Stocks.
1-14
The Historical Record:
Total Returns on U.S. Bonds.
1-15
The Historical Record:
Total Returns on T-bills.
1-16
The Historical Record:
Inflation.
1-17
Historical Average Returns
• Using the data in Table 1.1, if you add up the returns for large-company
stocks from 1926 through 2006, you get about 996 percent.
• Because there are 81 returns, the average return is about 12.3%. How
do you use this number?
• If you are making a guess about the size of the return for a year selected
at random, your best guess is 12.3%.
∑ yearly return
Historical Average Return = i =1
n
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Average Annual Returns for Five Portfolios
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Average Returns: The First Lesson
• Risk premium: The extra return on a risky asset over the risk-free
rate; i.e., the reward for bearing risk.
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Average Annual Risk
Premiums for Five Portfolios
1-21
Why Does a Risk Premium Exist?
• The Second Lesson: The greater the potential reward, the greater the
risk.
1-22
Return Variability: The Statistical Tools
∑(R − R )
N
2
i
VAR(R) = σ = 2 i =1
N −1
SD(R) = σ = VAR(R)
1-23
Return Variability Review and Concepts
1-24
Frequency Distribution of Returns on
Common Stocks, 1926—2006
1-25
Example: Calculating Historical Variance
and Standard Deviation
1-27
The Normal Distribution and
Large Company Stock Returns
1-28
Returns on Some “Non-Normal” Days
1-29
Arithmetic Averages versus
Geometric Averages
• When should you use the arithmetic average and when should you
use the geometric average?
1-30
Example: Calculating a
Geometric Average Return
(1.4870)^(1/5): 1.0826
• The arithmetic average tells you what you earned in a typical year.
• The geometric average tells you what you actually earned per year
on average, compounded annually.
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Geometric versus Arithmetic Averages
1-33
Risk and Return
• Second Lesson: Further, the more risk we are willing to bear, the
greater the expected risk premium.
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Historical Risk and Return Trade-Off
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A Look Ahead
• You will learn how to value different assets and make informed,
intelligent decisions about the associated risks.
• You will also learn about different trading mechanisms, and the way
that different markets function.
1-36
Useful Internet Sites
1-37
Chapter Review, I.
• Returns
– Dollar Returns
– Percentage Returns
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Chapter Review, II.
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