Notes on Capital Market History and Investment Returns

Learning Objectives

  • Calculate the return on an investment.
  • Discuss historical returns on various important types of investments.
  • Discuss historical risks on various important types of investments.
  • Explain implications of market efficiency.

Chapter Outline

  • Returns
  • The Historical Record
  • Average Returns: The First Lesson
  • The Variability of Returns: The Second Lesson
  • More about Average Returns
  • Capital Market Efficiency

Dollar Returns

  • Definition: Gain (or loss) from an investment.

  • Components of Return:

    1. Income Component: Cash received while holding the investment (e.g., dividends).
    2. Capital Gain/Loss: Change in the value of the asset.

  • Example: Buying 100 shares of a stock at $37 each:

    • Initial investment = $3,700
    • Dividend = $1.85 x 100 shares = $185 income by year-end.

  • End of Year Value: Stock price rises to $40.33, value of shares = $4,033.

    • Capital Gain: $4,033 - $3,700 = $333.

  • Total Dollar Return = Dividend + Capital Gain = $185 + $333 = $518.

Percentage Returns

  • Formula:

    • Dividend Yield:
      Dividend Yield=DividendBeginning Price\text{Dividend Yield} = \frac{\text{Dividend}}{\text{Beginning Price}}

  • Example: If stock price = $37, Dividend = $1.85; then:

    • Dividend Yield=1.8537≈0.050=5%\text{Dividend Yield} = \frac{1.85}{37} \approx 0.050 = 5\%.

  • Capital Gains Yield:
    Capital Gains Yield=Change in PriceBeginning Price\text{Capital Gains Yield} = \frac{\text{Change in Price}}{\text{Beginning Price}}

  • Total percentage return example:

    • If total investment was $1,000, you'd need to calculate total returns based on dividends and capital gains.

The Historical Record

  • Roger Ibbotson and Rex Sinquefield: Researched historical rates of return in U.S. financial markets, covering:

    1. Large-company stocks (S&P 500 Index)
    2. Small-company stocks (smallest 20% of NYSE)
    3. Long-term corporate bonds (20 years maturity)
    4. Long-term U.S. government bonds (20 years maturity)
    5. U.S. Treasury bills (1-month maturity)

  • Average Returns:

    • Large-company stocks: 12.0%
    • Small-company stocks: 16.0%
    • Long-term corporate bonds: 6.1%
    • Long-term government bonds: 5.6%
    • U.S. Treasury bills: 3.3%
    • Inflation: 3.0%

Risk Premium

  • Definition: Excess return expected from an investment in a risky asset compared to a risk-free investment (T-bills).
  • Calculation of Risk Premium:
    • Small-company stocks (Average Return: 16.0%) - T-bill rate (3.3%) = 12.7% Risk Premium.

The Variability of Returns

  • Variance: Measures the average squared deviation from the mean.

  • Standard Deviation: Square root of variance, indicates risk.

  • Example Calculation:

    • Returns: [10%, 12%, 3%, -9%]
    • Average return = 4%.
    • Deviations from Average: [0.06, 0.08, -0.01, -0.13].
    • Variance calculation steps:
    1. Square deviations.
    2. Sum and divide by number of returns - 1.

Capital Market Efficiency

  • Efficient Market Hypothesis (EMH): Prices reflect all available information.
    • Different forms:
    1. Weak form: Prices reflect past data.
    2. Semi-strong form: Prices reflect all public information.
    3. Strong form: Prices reflect all information, including inside information.
  • Important concepts:
    • Misconceptions about efficiency: Market efficiency does not suggest that it’s irrelevant how you invest; fluctuations in prices are normal.

Conclusion

  • Implications of Market History: Historical analysis supports risk-return relationship; greater potential rewards generally involve greater risks.
  • Investing strategies must consider these factors to manage risk effectively.