Download CHAPTER 5: RISK AND RETURN

Investments:
Theory and Applications
Mark Hirschey
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Chapter 5
Risk and Return
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KEY TERMS
 saving
 nominal risk-free rate
 investing
 risk-free rate of return
 inflation
 cash reserves
 U.S. Treasury bills
 required risk premium
 total return
 U.S. Treasury notes
 nominal return
 U.S. Treasury bonds
 real return
 bonds
 common stock
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Distinguishing
Saving from Investing
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Saving
 The terms saving and investing are used
interchangeable

But there are several important differences
 Saving: is an accumulation of money to meet
some short-term goal.

New car

Down payment on a new house
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Saving
 Savings vehicles include:

Bank money market accounts

Certificates of deposit



Fixed rate of interest
Government protection again loss
Money market mutual funds:


No government guarantee against loss of principal
May have fluctuating yields
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Saving
 Funds put into savings accounts don’t remain with the
bank:

Funneled out into the economy by the bank as loans to
borrows
 Generates interest income for the bank in excess of the
amount paid to savers



Bank takes on the credit risk of loaning the money vs. the
individual saver
Loan processing
Credit evaluation services
– i.e. interest rates on loans are typically higher than the interest rates
paid to savers.
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Saving
 No potential for capital gain
 Involves only a minimal risk of loss
 After-tax rates of return often fail to keep pace
with Inflation: Rising prices
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Investing
 Investing: Assuming measured risk in the
pursuit of higher rates of return over an
extended period.

Putting money to work to directly capitalize on
economic growth
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Investing
 Investors are more directly responsible than
savers for funneling their investment dollars
directly into the economy to generate income





(i.e. stocks and bonds)
Take on more risk than savers
Potential for higher returns
Results in rates of return that significantly outpace
inflation
Short-term losses can be substantial
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Types of
Financial Assets
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Cash Reserves
 Cash Reserves: short term money market
instruments


Money Market: the market used for buying and
selling short-term debt securities that can be quickly
converted into cash
Offer modest income with stability of principal
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Cash Reserves
 One of the most common uses of cash reserves
is to buy Treasury-bills - U.S. Treasury
obligations with maturities of one year or less
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Cash Reserves
 By contrast:
 Treasury-notes – U.S. Treasury obligations with
maturities of more than one year but less than 10
years
 Treasury-bonds – U.S. Treasury obligations with
maturities of 10 years or more.
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Cash Reserves
 Bank Savings Deposits: accounts that pay very
low levels of interest, don’t have any specific
maturity, and usually can be withdrawn on
demand.
 Bank Certificate of Deposit (CD) - a bank
savings deposit with a specific time of maturity,
that cannot be withdrawn on demand, put pays a
somewhat higher rate of interest.
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Bonds
 Another important class of investment assets
are:

Bonds: interest-bearing debt obligations issued
by:



Corporations
The federal government and its agencies
State and Local Governments
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Bonds
 Bonds represent:
 A loan to the issuer
 Provide income during their lifetime
 A promise to repay principal on maturity
 Bonds:
 Generally offer higher and steadier income than cash
reserves
 Principal value fluctuates as interest rates change



Inverse relationship between bond prices and interest rates
When interest rates rise, bond prices decline.
When interest rates decline, bond prices rise.
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Bonds
 U.S. Department of the Treasury Bonds
 One of the largest classes of outstanding bonds in a wide
variety of debt securities
 U.S. Government Agency Bonds
 Federal Home Loan Mortgage Corporation
 Corporate Bonds
 Issued by individual firms
 Municipal Bonds
 Interest-bearing securities issued by local governments
 Typically free of federal income taxes
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Stock
 Stock: A proportionate ownership stake in a
corporation

Offer the potential for current income from
dividends and capital appreciation
 Offer the long-term potential for superior rates of
return as compared to bonds
 More susceptible to short-term price risks

Stock prices fluctuate over short time periods
– Volatility can be violent
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Stock
 At any point in time, the market value of a
firm’s common stock depends on many factors:

The company’s current profitability

Growth prospects

Interest rates

Conditions in the overall stock market
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Stock
 Stocks appeal to long-term investors

Potential to provide competitive returns through
dividends and capital growth
 Over the “long term”, stocks have
consistently offered investors the “best”
opportunity to:

Stay ahead of inflation

Increase the value of their investment
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Figure 5.1
Common stocks provide potential
income from dividends and long-term
capital appreciation.
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Measuring
Historical Returns
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Components of
Required Return
 Investors evaluate the attractiveness of
investments based on a necessary trade-off
between:

Risk and Expected Return
 The cost of higher expected return is the
necessity of having to accept greater risk.

Positive relationship between risk and expected
return

If Risk goes up  Expected Return goes up!
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Components of
Required Return
 Required Return consists of two main
components:



The first component is reward for postponing
consumption
Because investors must forego consumption to invest,
they demand a monetary reward for postponing
consumption (nominal risk-free rate) as part of their
expected return.
The nominal risk-free rate consists of:
The risk-free rate of return – return w/o chance of default or
volatility (T-bill return) plus
 An amount equal to the expected rate of inflation
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
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Components of
Required Return
 The second component of required return is the
required risk premium: necessary
compensation for risk taking.

Compensation for taking risks associated with
default, inflation, volatility, or other risks



Varies with the amount of risk entailed
High-risk investments involve a higher-risk
premium
Low-risk investments involve a lower-risk
premium
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Components of
Required Return
 Required Return =

Nominal risk-free rate +


= Risk-free rate + Expected inflation
Required risk premium
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Components of
Required Return
 Required Return is:

Higher on long-term bonds than short-term money
market instruments


Long term bonds are more sensitive to interest rates.
Higher on equities than on long-term bonds and
money market instruments.

Common stocks have greater volatility
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Arithmetic Average
versus Geometric Mean
 Skip this section
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Jackrabbit Fund
 Skip this section
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Historical Returns
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Stocks
in the Long Run
 Per the DJIA Index: in the previous 72 years (1928 –
2000):

Total Returns were:

Positive in 54 years
– 75% of the time

Negative in only 18 years
– 25% of the time


Investors are realistic when they project total returns of 10
– 15% per year from a diversified portfolio of common
stocks.
Stocks usually go up!
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Stocks versus
Fixed-Income Securities
 Table 5.3 – Page 174 shows:
 Total Returns (1950 to 99):
 Common Stocks: 14.84%


Positive rates of return have been enjoyed by common
stockholders during most years
Common stock investors suffered losses during only 10 years

Long-Term Treasury Bonds: 6.07%
 Short-Term Treasury Bills: 5.16%
 Inflation Rate: 4.04%
 Common stocks have offered the highest average annual returns of the
primary classes of investment assets: Stocks, Bonds, Cash Reserves
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Stocks versus
Fixed-Income Securities
 Table 5.3 uses the Standard & Poor’s (S & P)
500 Index to represent the stock market
 S&P 500 Index:

A good proxy for large-company stocks

A common investment benchmark for institutional
investors

S & P Index firms are chosen on the basis of their
significant market capitalization.
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Stocks versus
Fixed-Income Securities
 Total Return – the sum of:

Dividends

Interest income and

Capital gains or capital losses
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Stocks versus
Fixed-Income Securities
 Unusually good or unusually bad stock return
performance is typically followed by periods of
above-normal performance

Stock prices rebounded in 1958 from the deep
bear market of 1957

The bear market of 1973-74 represented a severe
correction from the market peak of 1972
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Stocks versus
Fixed-Income Securities
 A fall in inflation proves to be a tonic for bull
markets in both stocks and bonds.
 Interest rates on Treasury bills tend to track the
rate of inflation.
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 Inflation: general increase in cost of living

Reduces the value of any investment
 Nominal Return: gross investment profit
expressed as percentage

Income taxes are typically paid on nominal returns
 Real Return: investment return after inflation

If Nominal Return is 6% and Inflation is 4%, Real
Return is only 2%
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 With dual threats of taxes and inflation, the
“bond” investor finds that the real value of their
investment tends to erode over time:

With a 40% Marginal Income Tax rate

Bond paying 6% interest


After tax rate of interest = (.06 x .60) 3.6%
If inflation is 4% - the bond investor has fallen
behind

After- tax Interest earned =

3.6% - 4% inflation = -.40%
This is also true for “money market” instruments
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 After accounting for both inflation and income taxes at
40%, the real after tax rate of return has been:

4.17% on Stocks

-0.64% on Treasury bonds

-0.90% on Treasury bills
 Fixed-income (bond) investing is largely a losing
proposition
 Over the long term, “Common Stocks” are the only
investment class with a documented record of providing
investors with meaningful real returns after taxes!
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Cumulative Returns
 The modest average annual return advantage of
“Common Stocks” over “Fixed-Income” securities
accumulates to a stunning total differential over an
extended investment horizon!
 Table 5.4 – Page 176

A $1 investment in common stocks in 1950 compounded to
a total value of $589.38 by the end of 1999.

More than 47 times the $12.38 cumulative value of a
similar $1 investment in Treasury bonds.
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Cumulative Returns
 The probability of outperforming a portfolio of
stocks with long-term bonds over a 30-year
holding period is roughly 0%.!
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Figure 5.2
The Power of Cumulative
Returns
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Cumulative Returns
 Very realistic to think in terms of long
investment horizons
 A long investment horizon is relevant for the
typical investor:

Students who are 20-30 years old


Have an investment horizon of 30-40 years to finance
retirement income
Even investors who are 40-50 years of age

have time to benefit significantly through long-term
investing
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Cumulative Returns
 Long-term average-rates-of-return are apt to be
replicated in the future.

Common stock investors benefit from rising
earnings and dividend income made possible by
“economic growth”.

Common stock investors will benefit so long as
“economic growth” is robust.

It’s been robust in the U.S. and much of the world for
generations.
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Cumulative Returns
 For all long-term investors:

it pays to carefully consider the longterm advantages of “Common Stock”
investing!
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Risk Concepts and
Measurement
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Valuation Risk
 Valuation Risk: chance of loss due to relatively
high stock prices (overpriced stocks)

Near term stock market performance is very
unpredictable

What’s “low” and what is “high” are typically not
known until it’s too late to profit from the knowledge
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Valuation Risk
 In the short run of a few years, stock prices
can and do race ahead of basic improvements
in the firm’s ability to increase earnings and
dividends. (Iowa Farm Land Example)
Stock prices have often “rested” while earnings
and dividends “catch up” and justify higher prices.
 Stock prices sometimes correct sharply to lower
levels, and then move upward when earnings
growth resumes.


1987 correction
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Valuation Risk
 It’s highly unlikely that returns for equity
investors over the next few years will approach
the above-average returns earned during the
1980’s and 1990’s

Annualized return of the S&P 500 Index was
17.87%
 Going forward, investors should be prepared for
the possibility of significant short-term
downward volatility.
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Risk Measurement
Concepts
 Standard Deviation: A common risk measure

Measures of return volatility

Volatility results from both upward and downward
price movements.
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Risk Measurement
Concepts
 Correlation: is a relative measure of co-
movement that varies between –1 and +1.

-1 means that returns from two asset classes are
perfectly inversely correlated



Move in opposite directions
A positive return of 10% in one asset class would correspond with
a negative return of –10% in some other asset class.
+1 means that returns from two different asset
classes are perfectly in sync

They move in lock-step fashion up and down together.
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Holding Period Returns
 Common stocks have consistently provided the
highest average annual rate of return to
long-term investors.

However: this average involves a substantial
amount of “year-to-year” variation.
 Long-term bond investing involves a
substantial variation in “year-to-year” rate of
return as well.
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Holding Period Returns
 Adopting an extended investment horizon, or
holding period, is the simplest means available
to long-term investors for “smoothing out” the
effects of year-to-year volatility in the rates of
return on common stocks and long-term
bonds.

Over the long-run, investors in stock and long-term
bonds can mitigate risk by sustaining their
investments for an extended period of time.
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Holding Period Returns
 Over an extended time horizon

There’s an extraordinarily high probability of
outperforming bonds with stocks

There’s a very high probability that stocks will
provide a more satisfactory hedge against inflation
than that provided by bond investments.

Per Table 5.6 – Page 184
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Holding Period Returns
 Over long investment horizons of five, 10,
or 20 years:



Stocks offer the highest positive returns
after taxes and after inflation
Next best are long-term bonds – but they
break even (at best) after taxes and inflation
Short-term Treasury bills and money
market instruments deplete capital
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Holding Period Returns
 When planning for retirement:

Stocks beat Bonds!
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Sources of Volatility
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Company Risk
 By owning individual stocks and bonds, the investor is
exposed to Firm-Specific Risk: chance that problems with
the individual company will reduce investment value

Quality of management, operating and financial leverage,
changes in product quality, etc. of a particular firm(s).

Can be eliminated through

Diversification

Mutual Funds - a convenient and low-cost way for investors to
avoid firm-specific risk
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Stock Market Volatility
 Although company fortunes rise or fall based on
the success of management’s efforts, such
success is not fully within the control of
company management.
 Market Risk: general fluctuations in stock and
bond prices
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Stock Market Volatility
 Unanticipated changes in the overall economic
environment cause roughly 1/3 of the volatility
in common stock returns.

Growth in aggregate economic activity (GDP)

Pace of Inflation

Interest rate changes

Fluctuation in the value of the dollar
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Stock Market Volatility
 The longer an investor holds a broadly
diversified portfolio of stock or bond
investments:

The lower is the chance of losing money

The greater the odds of earning a return close to
the long-term average.
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Stock Market Volatility
 Short-run stock returns are volatile.

Driven by changing investor expectations
manifested in hope and fear.

The DJIA and S&P 500 can routinely vary by 1% 3% in a single day.

High P/E & P/B ratios usually signify high risk

Low P/E & P/B ratios signal low valuation risk:

chance of loss due to relatively high stock prices.
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Stock Market Volatility
 Long-run returns on equity investment are
determined by “fundamental” economic factors


Dividend yield
The rate of growth in dividends and earnings
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Stock Market Volatility
 For investors with long-term goals (retirement):

Bond and money-market investments have little
day-to-day price volatility

But little chance of keeping pace with inflation

Especially after taxes
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Stock Market Volatility
 Reversion to the Mean: Tendency of stock
and bond returns to return toward long-term
averages. (An inherent characteristic of
economic and stock market environments)
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Stock Market Volatility
 Robust periods of economic expansion


Rising stock prices
Growing investor enthusiasm
 Subsequent periods of more tepid economic
growth



Relatively lackluster market environments
Stagnant or falling stock prices
Investor pessimism
 Rapid economic growth

Bullish market environments
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Bond Market Risk
 The bond market is also influenced by
economic expectations

During economic expansions: surges in the
demand for credit to finance new plant and
equipment

Higher interest rates adversely affect the value of
outstanding bonds
– PV of the bond goes down.
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Bond Market Risk
 Bond market volatility can be significant

As interest rates rise, bond prices fall.

When rates fall, bond prices rise
 Price volatility depends on the bonds maturity

The longer the maturity of a bond, the greater its
sensitivity to interest rates

Short-term bonds that mature in 2 – 5 years are the
least risky
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Bond Market Risk
 Interest Rate Risk: chance of loss in value of
fixed-income investments following a rise in
interest rates

Decreases the PV of the bond

No longer earning the market rate of interest
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Bond Market Risk
 Bond investors are also subject to Credit Risk:
chance of loss due to issuer default

The chance that an individual issuer of a bond will
fail to make timely payments of interest and
principal.
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Bond Market Risk
 Low-quality bonds

Have a greater risk of default

Generally offer higher yields to compensate investors
 Government bonds

Have the lowest risk of default

Carry the highest credit ratings

Offer the lowest yields
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Conclusion
 For all long-term investors: it pays to
carefully consider the long-term advantages
of “Common Stock” investing!
 Over the long term, “Common Stocks” are
the only investment class with a documented
record of providing investors with
meaningful real returns after taxes!
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Answers to Selected
End of Chapter 5 Questions
and Suggested Study
 Study the following end-of







chapter questions:
1. (d)
4. (a)
7. (b)
8. (d)
9. (d)
10. (c)
11. (d)
14. (d)
 17. (b)
 18. (c)
 Read the Chapter
 Read the Chapter
“Summary”
 Review the Power
Point Presentation
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