Chapter 9

Risk and Return: Lessons from Market History

Monetary Returns

Dividend
Income

Total
Monetary
Return
Capital
Gains
Monetary Return
You purchase 100 shares at £37 each:
Total Investment = £3,700
Scenario 1: Scenario 2:
Dividend: £1.85 per share Dividend = £1.85 per share
Share price = £40.33 Share price = £34.78
Total Monetary Return = Total Monetary Return =
(£1.85 + £40.33 - £37) x 100 (£1,85 + £34.78 - £37) x 100
= £518 = -£37
Percentage Returns

Dividend
Yield

Percentage
Return
Capital
Gains
Yield
Percentage Returns

Capital Gains Percentage

Dividend Yield
Yield Return

• Divt+1/Pt • (Pt+1– Pt)/Pt • Dividend

Yield +
Capital Gains
Yield
 Percentage Returns
• P0 = £37; Div1 = £1.85; P1 = £40.33
Dividend yield = Div t +1 /Pt Capital gain = (Pt  1  Pt )/Pt
= £1.85/£37 = (£40.33  £37)/£37
= .05 = 5% = £3.33/£37
= .09 = 9%

Divt 1 (Pt 1  Pt )
Rt 1  +
Pt Pt
= 5% + 9%
= 14%
Holding Period Returns

Holding Period Return

R = (1 + R1)  (1 + R2) 
is the return you earn
. . .  (1 + Rt)  . . .  (1
from holding an asset
+ RT )
for many periods
Holding Period Returns Example

• The returns for The Netherlands in 2005, 2006, and

2007 were 25.28%, 16.44%, and 4.81%,
respectively. How much would an investment of €1
at the beginning of 2005 have been worth at the
end of 2007?
(1 + R1)  (1 + R2 )  (1 + R3 ) = (€1 + .2528)  (€1  .1644)  (€1 + .0481)
= €1.2528  €1.1644  €1.0481
= €1.53
Return Statistics
• The history of capital market returns can be
summarized by describing the
• average return
( R1    RT )
R
T
• the standard deviation of those returns

( R1  R ) 2  ( R 2  R ) 2   ( RT  R ) 2
SD  Var 
T 1
 Risk Statistics: Variance and
Standard Deviation

• The returns on China’s stock market between 2004

and 2007 are -.1523, -.0821, 1.3057, and .9614,
respectively. What is the variance and standard
deviation of China’s returns?
1
[( R1  R ) + ( R2  R ) + ( R3  R ) + ( R4  R ) ]
2 2 2 2
Var =
T 1
1
.5420 = [(-.1523  .5082) + (-.0821  .5082)
2 2
3
+ (1.3057  .5082) + (.9614  .5082) ]
2 2

SD = .5420 = 0.7362 or 73.62%

 Average Stock Returns and Risk
Free Returns: Risk Premiums

Risk Premium = The higher the risk

(return on a risky premium, the
asset) – (risk free more risky the
return) investment

Government
Treasury bills are
used as the risk-
free asset
 Risk Statistics: Example of Risk premium
• Assume a T-bond gives a risk-free return of 5%. On the other
hand you can buy a stock at P = 100 that pays no dividend and
next year its price is expected to be either 100 or 110, i.e. its
expected return is also 5% (= (105 – 100) / 100).
• Risk-averters would prefer the T-bond; Risk-neutrals are
indifferent; Risk-lovers would prefer the stock.
• If a few investors are risk-lovers, the stock price might go down
to 90, (and up again, 110 or 100) until it gets attractive. The
stock expected return now is (105 – 90) / 90 = 16.67%.
• Risk premium = 16.67% - 5% = 11.67%
 Average Stock Returns and Risk-
Free Returns: Total US Annual Returns 1926-2005
Risk Premium
Arithmetic (relative to U.S. Standard
Series Mean Treasury bills) Deviation
Large-Company Shares 12.3% 8.5% 20.2%
Small company Shares 17.4 13.6 32.9
Long-term corporate bonds 6.2 2.4 8.5
Long-term government bonds 5.8 2.0 9.2
Medium-term government bonds 5.5 1.7 5.7
U.S. Treasury bills 3.8 3.1
Inflation 3.1 4.3
 Return Statistics: Frequency
Distribution for Large US Stocks
 Return Statistics: Frequency
Distribution for Small US Stocks
 Stock Return Distributions:
The Normal Distribution

The probability that a yearly return will fall within 20.2 % above
or below of the mean of 12.3 % by 1 sigma (= 1 SD), will be 68%.

19
Risk Statistics from Morningstar
Geometric Average Returns
• Geometric average return
• = [(1 + R1)  (1 + R2)    (1 + RT)]1/ T  1

• Arithmetic mean return

(R1 + · · · + R T )
Mean = R 
T
 Example 9.4:
Calculating Geometric Returns

 Calculate the geometric average return for Italian stocks for 2003-
2007.
 Step 1:
Milan Index Returns Product
27.08 1.2708
12.62  1.1262
6.57  1.0657
32.37  1.3237
-13.80  .8620
1.7403

 Step 2:

 Geometric average return = 1.74031/5  1 = .1172, or 11.72%

 Geometric vs Arithmetic Mean
Return for US Stocks: 1927-2005
Geometric Arithmetic Standard

Series Mean Mean Deviation

Large-company shares 10.4% 12.3% 20.2%

Small-company shares 12.6 17.4 32.9
Long-term corporate bonds 5.9 6.2 8.5
Long-term government bonds 5.5 5.8 9.2
Intermediate-term government bonds 5.3 5.5 5.7
U.S. Treasury bills 3.7 3.8 3.1
Inflation 3.0 3.1 4.3
Arithmetic or Geometric Returns?

Arithmetic Geometric

• Tells you what • Tells you what

you earn in a you actually
typical year earned per year
on average,
compounded
annually
 Arithmetic or Geometric?
 Start with 100, no change first year, decrease to 50 next year and
increase to 100 the third year.
Geometric average return 
Year Return
(1  rg ) 3  (1  r1 )  (1  r2 )  (1  r3 )
1 0%
2 -50% rg  3 (1)  (1  0.5)  (1  1)  1
3 100%
 0%
r1  r2  r3
Arithmetic average return 
3
0%  50%  100%
  16.67%!!!
3
Arithmetic vs. Geometric Mean
• The geometric average will be less than the
arithmetic average unless all the returns are equal
• Which is better?
• The arithmetic average is overly optimistic for long
horizons
• The geometric average is overly pessimistic for short
horizons
• So the answer depends on the planning period under
consideration
• 15 – 20 years or less: use arithmetic
• 20 – 40 years or so: split the difference between them
• 40 + years: use the geometric

26
 Average Returns: Blume’s Formula

T 1 N T
R(T ) =  Geometric average +  Arithmetic average
N 1 N 1
• from 25 years of annual returns data, we calculate an arithmetic
average return of 12 percent and a geometric average return of
9 percent. What are the 1-year, 5-year, and 10-year average
return forecasts?

11 25  1
R(1) =  9% +  12% = 12%
24 24
5 1 25  5
R(5) =  9% +  12% = 11.5%
24 24
10  1 25  10
R(10) =  9% +  12% = 10.875%
24 24
 Stock Market Performance of
Selected Countries
 Annual Stock Market
Index Levels 2000 - 2007

Netherlands

Kingdom
Germany

Thailand
Norway
France

United

United
States
China
Year

Italy

The
2000 100 100 100 100 100 100 100 100 100

2001 78.11 79.05 76.46 75.16 79.05 86.89 112.88 84.59 89.79

2002 64.73 54.45 55.69 61.14 51.66 64.98 132.43 63.47 71.99

2003 71.57 63.94 47.07 77.69 54.54 96.14 286.84 73.98 92.73

2004 60.67 69.85 56.16 87.50 57.74 133.68 248.19 80.79 104.38

2005 55.69 87.53 67.75 93.24 72.34 203.46 265.14 95.42 111.64

2006 128.41 104.48 84.28 123.43 84.23 271.28 252.55 107.96 131.58

2007 251.85 104.91 108.32 106.39 88.28 307.78 318.77 110.15 140.24
 Annual Stock Market Returns (%)
2000 - 2007

Netherlands

Kingdom
Germany

Thailand
Norway
France

United

United
States
China
Year

Italy

The
2000 - - - - - - - - -

2001 -21.89 -20.95 -23.54 -24.84 -20.95 -13.11 12.88 -15.41 -10.21

2002 -17.13 -31.13 -27.17 -18.65 -34.65 -25.22 17.32 -24.97 -19.83

2003 10.57 17.45 -15.47 27.08 5.56 47.96 116.60 16.56 28.81

2004 -15.23 9.23 19.31 12.62 5.88 39.05 -13.48 9.21 12.57

2005 -8.21 25.31 20.64 6.57 25.28 52.19 6.83 18.10 6.95

2006 130.57 19.37 24.40 32.37 16.44 33.34 -4.75 13.15 17.86

2007 96.14 0.41 28.52 -13.80 4.81 13.45 26.22 2.03 6.58
Stock Return Distributions: Skewness
Stock Return Distributions: Kurtosis
 Example 9.2:
Calculating Average Returns

• The returns on large French company shares

between 2004 and 2007 were .0923, .2531, .1937,
and .0041, respectively. What was the average, or
arithmetic mean, return over these four years?

.0923 + .2531 + .1937  .0041

R  .1358 or 13.58%
4