Chapter 12 Lessons from Capital Market History Homework

Chapter 12 Lessons from Capital Market History • Homework: 1, 7 & 14

Lecture Organization n Percentage Return n Historical Return and Risk Premium n Measure of Risk n 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 Percentage Return = +

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

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

Year-to-Year Total Returns on TSE 300: 1948 -1999

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

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

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

Using Capital Market History n Now let’s use our knowledge of capital market history to make some financial decisions. Consider these questions: u 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? u 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) n 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. Standard return deviation Common stocks 13. 2% 16. 6% Small stocks 14. 8% 23. 7% ____% LT Bonds 10. 6% ____% U. S. Common 15. 6% (S&P 500 in C$) 16. 9% Treasury bills 3. 8% ____% 7. 6% 3. 2% Risk premium ____%

TSE 300: Frequency of returns (1948 -1999): Figure 12. 5

Historical Returns and Standard Deviations: Investment Average. Standard return deviation Small stocks 14. 8% 23. 7% Common stocks 13. 2% LT Bonds 10. 6% 7. 6% Treasury bills 3. 8% 3. 2% 16. 6% 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 TSE 300 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

Expected Returns and Risk n Returns are important, but they can’t be the sole driver of investment decisions n Risk-free Rate u The rate of return that can be earned with certainty n Risk Premium u Difference between return and risk-free asset return n Volatility u The standard deviation of asset returns n Risk Aversion u The degree to which an investor is willing to accept risk

Do We Like Risk? n Coin-Flipping game n Wonderland King’s Island n Las Vegas

Example n 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

Efficient Market n Efficient Market Hypothesis (EMH) states that asset prices fully reflect all available information u Active strategies do not work systematically due to competitive market environment n EMH recommends a passive portfolio investment of investment in a well-diversified portfolio without attempting to find ‘mispriced’ securities.

Market Efficiency n Information is the key. Market prices incorporate information quickly. n What information is included in prices? u Weak form u Semi-strong form u Strong form All insider info All public info Past prices

Implications n Suppose markets are weak form efficient u Implies information from past trading history of security, or technical analysis, cannot help investors identify systematic mispricing. Why? n Suppose markets are semi-strong form efficient n Suppose markets are strong form efficient

Implications Strong Semistrong Weak

Implications n EMH implies stock prices are a Random Walk u 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: