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Investments: Theory and Applications Mark Hirschey Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Chapter 5 Risk and Return Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-3 Distinguishing Saving from Investing Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-5 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-6 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-7 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-8 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-9 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-10 Types of Financial Assets Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-12 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-13 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-14 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-15 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-16 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-17 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-18 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-19 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-20 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-21 Figure 5.1 Common stocks provide potential income from dividends and long-term capital appreciation. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-22 Measuring Historical Returns Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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! Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-24 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-25 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-26 Components of Required Return Required Return = Nominal risk-free rate + = Risk-free rate + Expected inflation Required risk premium Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-27 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-28 Arithmetic Average versus Geometric Mean Skip this section Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-29 Jackrabbit Fund Skip this section Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-30 Historical Returns Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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! Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-32 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-33 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-34 Stocks versus Fixed-Income Securities Total Return – the sum of: Dividends Interest income and Capital gains or capital losses Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-35 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-36 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-37 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% Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-38 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 Inc. items and derived items copyright © 2001 by Harcourt, Inc. Harcourt, 5-39 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! Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-40 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-41 Cumulative Returns The probability of outperforming a portfolio of stocks with long-term bonds over a 30-year holding period is roughly 0%.! Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-42 Figure 5.2 The Power of Cumulative Returns Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-43 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-44 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-45 Cumulative Returns For all long-term investors: it pays to carefully consider the longterm advantages of “Common Stock” investing! Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-46 Risk Concepts and Measurement Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-48 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-49 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-50 Risk Measurement Concepts Standard Deviation: A common risk measure Measures of return volatility Volatility results from both upward and downward price movements. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-51 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-52 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-53 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-54 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-55 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-56 Holding Period Returns When planning for retirement: Stocks beat Bonds! Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-57 Sources of Volatility Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-59 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-60 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-61 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-62 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-63 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-64 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-65 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) Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-66 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-67 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-68 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-69 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-70 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. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-71 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-72 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! Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-73 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 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5-74