Capital Markets 1

Risk and Return: Historical Perspective Historical Returns Market Efficiency

Capital Markets 2

Historical Returns 1926-2008

Average returns Arithmetic versus geometric

Risk premium = Return – risk-free return Compensation for taking risk

Standard deviation Measures variability of returns Two-thirds of the time returns should fall:

Capital Markets 3

Expected Return

Stock A Stock B

Probability Return Probability Return10% -15% -1.5% 20% -50% -10%

40% 10% 4% 30% 0% 0%

50% 25% 12.5% 50% 50% 25%

Expected Return 15% Expected Return 15%

Can Stock B have the same Expected

Return as Stock A???

Capital Markets 4

Historical Returns 1926-2008

Investment

Average

Return

Risk Premiu

mStandard Deviation

Large cap stocks 11.7% 7.9% 20.6%

Small cap stocks 16.4% 12.6% 33.0%

Long-term corporate bonds 5.9% 2.1% 8.4%

Treasury bills (Risk-free rate of return)

3.8% 0.0% 3.1%

Inflation 3.1% 4.2%

10/15/99 Wall Street Journal, equity risk premium has fallen from 10% in early 1980s to 2% in recent months…

Capital Markets 5

Unusual returns

S&P 500 Annual Return1995: 37.6% 1996: 23.0%1997: 33.4%1998: 28.6%1999: 21.9%

Capital Markets 6

Time In Market

One Year 25 Years

Return ReturnHigh 52.3% High 10.2%

Average 11.4% Average 8.9%

Low (2008…) -37.0% Low 7.9%

Capital Markets 7

Implications

Correlation of risk and rewardTo achieve above average returns, you

must take risk This can be done in an intelligent fashion!!!

Knowing your risk tolerance Time horizon: how long until I need this money? Diversification

Capital Markets 8

Time in Market

Investing for long-periods of time, likely you will have positive returns

Investing for long-period of time reduces risk. Time in market, not timing market is your

goal. In the short-run, anything can happen

Capital Markets 9

Reducing Risk While Obtaining Returns Diversify Invest for long-term

Capital Markets 10

Forms of market efficiency

Strong: all information is reflected in stock prices Including public and private information No one can outperform the market

What about Martha? Use of index funds

Diversification Efficiency

Underperformance by investors Average return large cap: Average return large cap mutual fund:

Expenses: management fees/trading costs

Average return large cap mutual fund investor:

Buying last period’s top performer

Capital Markets 11

Forms of market efficiency

Semi-strong: all publicly available information is reflected in stock prices Corporate financial analysis is a waste of time

Stock prices only react to “new” information differing from expectations

Questions: Assumes intelligent investors?

Valid assumption? Decline in inventory turnover ratio???

Assumes rational investors? Valid assumption?

Capital Markets 12

Forms of market efficiency

Weak: all prior stock price patterns reflected in stock pricesTechnical analysis is a waste of timeQuestion…

January effect…anomaly?? Sell losers, deduct losses up to $3,000 Hold winners, pay not tax until you sell