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Chapter 12
Lessons from Capital
Market History
•Homework: 1, 7 & 14
Lecture Organization
 Percentage Return
 Historical Return and Risk Premium
 Measure of Risk
 The Efficient Market Hypothesis
Risk, Return, and Financial Markets
“. . . Wall Street shapes Main Street. Financial markets
transform factories, department stores, banking assets,
film companies, machinery, soft-drink bottlers, and power
lines from parts of the production process . . . into
something easily convertible into money. Financial
markets . . . not only make a hard asset liquid, they price
that asset so as to promote it most productive use.”
Peter Bernstein, in his book, Capital Ideas
Percentage Returns
Total
$42.18
Inflows
Dividends
$1.85
Ending
market value
$40.33
Time
Outflows
t
– $37
t=1
Percentage Returns
Rates of Return
D
+ (P
-P)
t+1
t+1
t
Percentage Return =
Pt
D
t+1
Percentage Return =
P
t
(Pt+1 - P t)
+
P
t
A $1 Investment in Different Types of Portfolios: 1948-1999
1000
TSE 300 Stocks
Index
100
Long Bonds
10
Treasury bills
1
1945
1955
1965
1975
Small Stocks
0.1
Year
1985
1995
A $1 Investment
in Different Types of Portfolios:
1926-1998 (US Comparison)
Year-to-Year Total Returns on TSE300: 1948-1999
TSE300
60
50
40
30
20
10
0
Year 1950
-10
-20
-30
1965
1980
1995
Year-to-Year Total Returns on Small Company Common Stocks: 1970-1999
Small Company Stocks
60
50
40
30
20
10
0
1975
-10
-20
-30
-40
1985
1995
Year-to-Year Total Returns on Bonds: 1926-1998
Bonds
50
40
30
20
10
0
Year 1950
-10
-20
1965
1980
1995
Year-to-Year Total Returns on Treasury Bills: 1948-1999
Treasury Bills
25
20
15
10
5
0
Year 1950
1965
1980
1995
Using Capital Market History
 Now let’s use our knowledge of capital market history to
make some financial decisions. Consider these questions:

Suppose the current T-bill rate is 5%. An investment
has “average” risk relative to a typical share of stock. It
offers a 10% return. Is this a good investment?

Suppose an investment is similar in risk to buying
small Canadian company equities. If the T-bill rate is
5%, what return would you demand?
Using Capital Market History (continued)
 Risk premiums: The risk premium is the difference between a
risky investment’s return and that of a riskless asset. Based on
historical data:
Investment
Average
return
Standard
deviation
Risk
premium
Common stocks
13.2%
16.6%
____%
Small stocks
14.8%
23.7%
____%
7.6%
10.6%
____%
15.6%
16.9%
____%
3.8%
3.2%
____%
LT Bonds
U.S. Common
(S&P 500 in C$)
Treasury bills
TSE 300: Frequency of returns (1948-1999): Figure 12.5
9
8
6
5
4
3
2
1
55
45
35
25
15
5
-5
-1
5
0
-2
5
Frequency
7
Historical Returns and Standard Deviations:
Investment
Average
return
Standard
deviation
Small stocks
14.8%
23.7%
Common stocks
13.2%
16.6%
LT Bonds
7.6%
10.6%
Treasury bills
3.8%
3.2%
Frequency
The Normal Distribution
Probability
68%
95%
> 99%
–3
–2
–1
0
– -36.22% – -19.77% – -3.32% 13.13%
+1
29.58%
+2
46.03%
+3
62.47%
Return on
large company
stocks
Asset mean returns versus variability: 1948-1999
Mean
Inflation
4.25
T-bills
6.04
Bonds
7.64
TSE300
13.20
Small Stocks 14.79
Standard
Deviation
3.51
4.04
10.57
16.62
23.68
Asset mean returns versus variability: 1948-1999
Average returns versus variability
16
Average Return (%)
14
Small
Stocks
TSE300
12
10
8
Bonds
6
T-bills
4
2
0
4
9
14
Variability (std dev)
19
24
Expected Returns and Risk
 Returns are important, but they can’t be the sole driver of investment
decisions
 Risk-free Rate
 The rate of return that can be earned with certainty
 Risk Premium
 Difference between return and risk-free asset return
 Volatility
 The standard deviation of asset returns
 Risk Aversion
 The degree to which an investor is willing to accept risk
Do We Like Risk?
 Coin-Flipping game
 Wonderland and King’s Island
 Las Vegas
Example
 Using the following returns, calculate the average returns,
the variances, and the standard deviations for stocks X
and Y.
Returns
Year
X
Y
1
18%
26%
2
6
-7
3
-9
-20
4
13
31
5
7
16
Solution to Example
Mean return on X =
Mean return on Y =
Variance of X =
Variance of Y =
Standard deviation of X
=
Standard deviation of Y
=
Two Views on Market Efficiency
“ . . . in price movements . . . the sum of every scrap of
knowledge available to Wall Street is reflected as far as the
clearest vision in Wall Street can see.”
Charles Dow, founder of Dow-Jones, Inc. and first editor of
The Wall Street Journal (1903)
“In an efficient market, prices ‘fully reflect’ available
information.”
Professor Eugene Fama, financial economist (1976)
Reaction of Stock Market to
New Information
250
Overreaction
200
150
Delayed Reaction
Efficient Reaction
100
50
0
-8
-6
-4
-2
0
2
4
6
8
Efficient Market
 Efficient Market Hypothesis (EMH) states that asset prices fully reflect
all available information
 Active strategies do not work systematically due to competitive
market environment
 EMH recommends a passive portfolio investment of investment in a
well-diversified portfolio without attempting to find ‘mispriced’
securities.
Market Efficiency
 Information is the key. Market prices incorporate information quickly.
 What information is included in prices?
 Weak form
 Semi-strong form
 Strong form
All insider info
All public info
Past
prices
Implications
 Suppose markets are weak form efficient
 Implies information from past trading history of security, or technical
analysis, cannot help investors identify systematic mispricing. Why?
 Suppose markets are semi-strong form efficient
 Suppose markets are strong form efficient
Implications
Strong
Semistrong
Weak
Implications
 EMH implies stock prices are a Random Walk
 Stock price changes should be random and unpredictable
(Why? Is this bad?)
Empirical Evidence on Market Efficiency
The Empirical Evidence tells us three main things: