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

Inflows

Outflows

$42.18

$1.85

$40.33

Total

Dividends

Endingmarket value

t = 1t

– $37

Time

Percentage Returns

Rates of Return

Dt+1 + (Pt+1 - Pt)

PtPercentage Return =

Dt+1

(Pt+1 - P t)

Pt Pt+Percentage Return =

A $1 Investment in Different Types of Portfolios: 1948-1999

0.1

1

10

100

1000

1945 1955 1965 1975 1985 1995

Year

Ind

ex

TSE 300 Stocks

Long Bonds

Treasury bills

Small Stocks

A $1 Investment in Different Types of Portfolios: 1926-1998 (US Comparison)

Year-to-Year Total Returns on TSE300: 1948-1999

TSE300

-30

-20

-10

0

10

20

30

40

50

60

Year 1950 1965 1980 1995

Year-to-Year Total Returns on Small Company Common Stocks: 1970-1999

Small Company Stocks

-40

-30

-20

-10

0

10

20

30

40

50

60

1975 1985 1995

Year-to-Year Total Returns on Bonds: 1926-1998

Bonds

-20

-10

0

10

20

30

40

50

Year 1950 1965 1980 1995

Year-to-Year Total Returns on Treasury Bills: 1948-1999

Treasury Bills

0

5

10

15

20

25

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?

Risk premiums: The risk premium is the difference between a risky investment’s return and that of a riskless asset. Based on historical data:

InvestmentAverage Standard Riskreturn deviation premium

Common stocks 13.2% 16.6% ____%

Small stocks 14.8% 23.7% ____%

LT Bonds7.6% 10.6% ____%

U.S. Common 15.6% 16.9% ____%(S&P 500 in C$)

Treasury bills 3.8% 3.2% ____%

Using Capital Market History (continued)

TSE 300: Frequency of returns (1948-1999): Figure 12.5

0

1

2

3

4

5

6

7

8

9

-25

-15 -5 5 15 25 35 45 55

Fre

qu

en

cy

Historical Returns and Standard Deviations:

InvestmentAverage Standard Frequencyreturn deviation

Small stocks 14.8% 23.7%

Common stocks 13.2% 16.6%

LT Bonds7.6% 10.6%

Treasury bills 3.8% 3.2%

The Normal Distribution

Probability

Return onlarge companystocks

68%

95%

> 99%

– 3 – -36.22%

– 2 – -19.77%

– 1 – -3.32%

013.13%

+ 1 29.58%

+ 2 46.03%

+ 3 62.47%

Asset mean returns versus variability: 1948-1999

StandardStandard Mean Mean DeviationDeviation

InflationInflation 4.25 3.51T-billsT-bills 6.04 4.04BondsBonds 7.64 10.57TSE300TSE300 13.20 16.62Small StocksSmall Stocks 14.79 23.68

Asset mean returns versus variability: 1948-1999

Average returns versus variability

0

2

4

6

8

10

12

14

16

4 9 14 19 24

Variability (std dev)

Ave

rag

e R

etu

rn (

%)

T-bills

Bonds

TSE300

Small Stocks

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

-8 -6 -4 -2 0 2 4 6 80

50

100

150

200

250

Efficient Reaction

Delayed Reaction

Overreaction

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

Past prices

All public info

All insider info

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 Semi-strong

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: