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Lecture 5 Script

The document discusses basic properties of asset returns including risk and return for different asset classes using historical data from 1926-present. It finds that higher average returns are associated with higher risk/volatility, with stocks being the riskiest but highest returning asset class on average. Specifically, stocks have averaged 12-17% returns but with 20-30% volatility, while lower-risk assets like bonds and bills offered lower but steadier returns. The tradeoff between risk and return means different assets are suitable for investors with different risk tolerances.

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Ashish Malhotra
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9 views

Lecture 5 Script

The document discusses basic properties of asset returns including risk and return for different asset classes using historical data from 1926-present. It finds that higher average returns are associated with higher risk/volatility, with stocks being the riskiest but highest returning asset class on average. Specifically, stocks have averaged 12-17% returns but with 20-30% volatility, while lower-risk assets like bonds and bills offered lower but steadier returns. The tradeoff between risk and return means different assets are suitable for investors with different risk tolerances.

Uploaded by

Ashish Malhotra
Copyright
© © All Rights Reserved
Available Formats
Download as TXT, PDF, TXT or read online on Scribd
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We will now discuss the basic properties of asset returns.

We will look at some empirical data


to get a sense of the level of risk and return
in different asset classes, how they're related to each other.
Let's begin with some notation.
For any investment, the initial price, P0, is known.
The terminal price, P1, at the end of the period, is random.
It's unknown.
A period could be a month, a quarter, a year,
whatever is relevant for a given context.
At the end of the period, there are additional cash flows
that investment produces.
Let's call them dividends.
They're also random.
As a result, the total return on the investment
during the period, we call it R1,
is given by the dividend plus the capital gains, which
is P1 minus P0, divided by the initial value
of the investment.
So the total return comes from capital gains
and the dividends.
Or more precisely the dividend yield,
which is the ratio of D1 to P0.
The expected return is just the expected value of the return.
It's equal to the expected dividend plus expected terminal
price divided by the initial price minus 1.
It is common to use the concept of excess returns.
Excess returns are typically measured in relation
to the risk-free rate.
As the name suggests, excess return
is the return in excess of the risk-free rate.
So for each investment return, we
can subtract the risk-free rate, and we obtain
a measure of excess returns.
We will now introduce several basic statistics
that are commonly used to describe
the properties of returns.
Under the framework of mean variance preferences,
these are also the building blocks
of how we describe preferences over different investment
strategies.
They capture the average returns and return risk, or variance.
In particular, we'll talk about investment return mean, r bar,
the variance, sigma squared, and the standard deviation,
which is sigma.
Standard deviation is commonly called volatility of returns.
These moments, which form the basis of preferences
under the mean variance framework,
are not known in practice.
They need to be estimated.
They can be estimated using statistical techniques
based on historical data.
The most common estimators-- the most basic estimators--
corresponding to these population moments
are the sample mean, which corresponds to the population
mean or average return.
The sample variance, which is 1 divided by the sample
size minus 1 times the sum of squared deviations of returns
from their sample mean.
And the square root of the sample variance
is the sample standard deviation.
These are the most commonly used statistics
that we are going to employ now to describe
the properties of financial returns in the data.

Let's look at a few examples of the major asset classes


and their properties, their average returns,
and their standard deviations.
In particular, we are going to look at the history of returns
starting in 1926.
We will use annual data, and we'll be using nominal returns.
The least risky investment in our table are the T-bills.
This is as close as it comes to the risk-free rate in practice.
And the T-bills have low volatility and low returns.
The reason why they have any volatility at all
is because the risk-free rate changes over time.
It is not constant year to year.
Next in terms of the level of risk come bonds.
Treasury bonds and corporate bonds.
Their average returns are roughly twice as high
as for T-bills, and their level of volatility is quite a bit
higher, in the 8% to 10% range.
Stocks are even more volatile than bonds.
Volatility of stocks is in a 20% to 30% range.
And it's important to understand what we mean by that.
We are thinking about portfolios of stocks,
either large cap stocks.
This is a portfolio of companies with large market
capitalization.
Or small caps, portfolio of stocks with a low market
capitalization.
These portfolios are the most volatile in our table.
They have the highest volatility, 20%, 30%,
and perhaps higher.
And their average returns in sample are 12% to 17%.
What we can see from this table is a pattern
that suggests that when we compare different asset
classes to each other, higher returns come
with higher levels of risk.
This is a casual observation.
We need to learn how to better model
the relation between risk and return,
but this is the starting point.
There is no free lunch.
In order to achieve high levels of returns,
investors have to accept high levels of risk.
Now, the graph here represents visually
how quickly different investments allow one
to accumulate wealth.
There are several lines here.
Imagine you start with $100 at the end of the year in 1925.
You invest in a particular asset, T-bills, bonds, stocks.
And you keep rolling over your investment over time.
How quickly would your wealth accumulate?
As we can see from this graph, there
is in an order of magnitude difference between outcomes
at the end of this exercise, roughly a century later.
Investments in bonds, long-term treasury bonds
or corporate bonds, produced significantly higher levels
of wealth compared to T-bills.
Large cap stocks do even better, an order of magnitude higher
level of wealth.
Small cap stocks as an investment strategy
do even better than that.
This raises a question.
Why would any investor want to invest
in bonds when, in the long run, stocks perform so much better?
The answer lies in the risk return trade off.
Investing in stocks, in order to achieve high levels of returns,
comes with a much higher level of risk.
It is because of this risk return
trade off that all of these investments can coexist.
For some investors, stocks are more appealing.
Those investors have higher tolerance towards risk.
They are able to achieve higher levels of reward, higher
levels of expected returns.
For more conservative investors with lower levels
of risk tolerance, investing in bonds,
which are safer investments, is more appealing.

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