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Chapter 1
A Brief History of Risk and Return

Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-1

Learning Objectives

To become a wise investor (maybe even one with too

much money), you need to know:

• How to calculate the return on an investment using

different methods.

• The historical returns on various important types of

investments.

• The historical risks of various important types of

investments.

• The relationship between risk and return.

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A Brief History of Risk and Return

• Our goal in this chapter is to see what financial

market history can tell us about risk and return.

• There are two key observations:

―First, there is a substantial reward, on average, for
bearing risk.
―Second, greater risks accompany greater returns.

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Returns
• Return: is a reward for bearing risk.

Return

Dollar return Percentage return

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Dollar Returns
• Total dollar return is the return on an investment measured
in dollars, accounting for all interim cash flows and capital
gains or losses.

• So it has two components:

- Cash Received while you own investment (Dividends).
- The change in the value of assets you purchase (i.e. the
change in the value of your investment), that is, you may
have capital gain or loss.
• That is:

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Percent Returns
• How much do we get for each dollar we invest?
• Total percent return is the return on an investment measured as a
percentage of the original investment (i.e. originally invested sum).

• The total percent return is the return for each dollar invested.

• It accounts for all cash flows and capital gains or losses.

• It has two components:

- Dividend Yield: the annual stock dividend as a percentage of the initial
stock price. It tells you for each dollar invested how much you earn as
dividend.
- Capital Gain Yield: the change in stock price as a percentage of the
initial stock price. It tells you how much you earn as capital gain (loss) for
each dollar invested.

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Percent Returns (Cont.)

• You buy a share of stock, then:

OR

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Example: Calculating Total Dollar

and Total Percent Returns
• Suppose you invested $1,400 in a stock with a share price of $35.
• After one year, the stock price per share is $49.
• Also, for each share, you received a $1.40 dividend.

• What was your total dollar return?

― $1,400 / $35 = 40 shares
40 shares times $14 = $560
― Capital gain = Pt – Pt-1 = $49 - $35 = $14 / share
― Dividends: 40 shares times $1.40 = $56
― Total Dollar Return is C.G + Div. = $560 + $56 = $616

• What was your total percent return?

― Dividend yield = $1.40 / $35 = 4%
― Capital gain yield = ($49 – $35) / $35 = 40%
― Total percentage return = 4% + 40% = 44%
 For each dollar invested, you get 44 cents.
Note that $616 divided by
$1400 is 44%.

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Annualizing Returns, I.
• So far, returns are considered as annual returns.

• But the actual length of time you hold your

investment will never be exactly a year. It might be
less or more.

• As a result, the comparison between the returns of

two investment with different holding periods will be
difficult.

• So, we need to express returns on a per-year or

“annualized” basis.
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Annualizing Returns, I (Cont.)

• EXAMPLE 1:
• You buy 200 shares of Lowe’s Companies, Inc. at $48 per share. Three
months later, you sell these shares for $51 per share. You received no
dividends. What is your return? What is your annualized return?
This return is
• Return: (Pt+1 – Pt) / Pt = ($51 - $48) / $48 known as the holding
= .0625 = 6.25% period percentage
return.
• 6.25%, is the return for 3-month holding period. What does this return
amount to on a per-year basis?

• Effective Annual Return (EAR): The return on an investment expressed on

an “annualized” basis.

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Annualizing Returns, II

1 + EAR = (1 + holding period percentage return)m

m = the number of holding periods in a year.

Key Question: What is the number of holding periods
in a year?

• In this example, m = 4 (there are 4 3-month holding

periods in a year). Therefore:

1 + EAR = (1 + .0625)4 = 1.2744.

So, EAR = .2744 or 27.44%.
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Annualizing Returns, II (Cont.)

• EXAMPLE:
• You buy some shares in Johnson & Johnson at $50 per share. Three years later,
you sell these shares for $62.50 per share. You received no dividends. What is
your annualized return?

• % Return: (Pt+1 – Pt) / Pt = ($ 62.50 - $ 50) / $ 50

= .25 = 25% This is the return for 3-years holding
period
• The annualized return is:
1 + EAR = (1 + holding period percentage return)m
m
How many three-year holding periods are there in one year?
• there are one-third holding periods; m = 1/3

1 + EAR = (1 + .25)1/3 = 1.0772.

So, EAR = .0772 or 7.72%.

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A $1 Investment in Different Types

of Portfolios, 1926—2012

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Financial Market History

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The Historical Record:

Total Returns on Large-Company Stocks

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The Historical Record:

Total Returns on Small-Company Stocks

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The Historical Record:

Total Returns on Long-term U.S. Bonds

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The Historical Record:

Total Returns on U.S. T-bills

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The Historical Record: Inflation

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Historical Average Returns

• A useful number to help us summarize historical financial data is the simple, or
arithmetic average.

• Using the data in Table 1.1, if you add up the returns for large-company stocks
from 1926 through 2012, you get about1,020 percent.

• Because there are 87 returns, the average return is about 11.7%. How do you
use this number?

• If you are making a guess about the size of the return for a year selected at
random, your best guess is 11.7%.

• The formula for the historical average return is:

This formula says:

Starting with the first one,
add up each yearly return
(S says “sum”) and divide
by the number of years, n

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Average Annual Returns for

Five Portfolios and Inflation, 1926—2012

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Historical Average Returns: The Impact of

Inflation
• The average return calculated using previous formula does
not reflect the impact of inflation.

• Such returns called Nominal returns (i.e. they are the returns
as we ordinarily observe with no adjustment to inflation
rate).

• To reflect the impact of the inflation, we calculate the

difference between returns and the rate of inflation, which is
known as real return (it is so-called because it measures the
real change in purchasing power of the investment).

• Example: the average return on small-Cap stocks is 17.4%, the

inflation rate 3.1%, then the real return = 17.4% - 3.1% =
14.3%

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Average Annual Returns for Five Portfolios

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Average Returns: The First Lesson

• After computing some average returns, it seems logical to compare them with each
others.

• To compare, we should use a benchmark investment.

• Treasury Bills (TB) represents the benchmark. Why?

- Free of much of the variability; free of any default risk (i.e. risk-free assets).

• The rate of return on TB is known as risk-free rate.

• Risk-free rate: The rate of return on a riskless, i.e., certain investment.

• There is a difference when comparing risk-free return on T-Bills and the risky return on
common stocks; this difference can be interpreted as a measure of excess return on the
average risky asset.

• This difference is called excess return and it is also known as:

• Risk premium: The extra return on a risky asset over the risk-free rate; i.e., the reward for
bearing risk.

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Average Returns: The First Lesson (Cont.)

By looking at Table 1.4, we can see the risk premium earned by large-company stocks
was 8.0%!

•The fact that risk premium exists is an indication on the existence

of the reward for bearing risk.

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Why Does a Risk Premium Exist?

The First Lesson: There is a reward,

on average, for bearing risk; in other
words, Risky assets, on average,
earn a risk premium.

The main question that any one could ask is >>>>>>>>>>

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Why Does a Risk Premium Exist?

• What determines the relative size of the risk premium for the different assets?

• Modern investment theory centers on this question.

• Part of the answer could be related to the dispersion, or spread of historical

returns (i.e. variability in returns).

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Return Variability: Second Lesson

• We need to know how to measure the spread (i.e. variability) in returns. In

other words, we need to know how much the actual return differs from the
average return (i.e. we need to measure the volatility of returns).

• Two statistical concepts to study this dispersion, or variability:

Variance
Standard Deviation

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Return Variability: The Statistical Tools

• Variance is a common measure of return dispersion. Sometimes, return
dispersion is also called variability.

• It is calculated as the average squared difference between the actual

returns and the average return.

• The formula for return variance is ("n" is the number of returns):

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Return Variability: The Statistical Tools (Cont.)

• Standard deviation is the square root of the variance.
― Sometimes the square root is called volatility.
― Standard Deviation is handy because it is in the same "units" as the average, where as
the variance is measured in “squared” percentage, thus it is hard to interpret.

• Sometimes, it is useful to use the standard deviation, which is related to

variance like this:

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Example: Calculating Historical Variance

and Standard Deviation
• Let’s use data from Table 1.1 for Large-Company Stocks.

• The spreadsheet below shows us how to calculate the average, the

variance, and the standard deviation (the long way…).

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Example: Calculating Historical Variance

and Standard Deviation
• Let’s use data from Table 1.1 for Large-Company Stocks.

• The spreadsheet below shows us how to calculate the average, the

variance, and the standard deviation (the long way…).

(1) (2) (3) (4) (5)

Average Difference: Squared:
Year Return Return: (2) - (3) (4) x (4)
1926 0.1114 0.1148 -0.0034 1.16E-05
1927 0.3713 0.1148 0.2565 0.065792
1928 0.4331 0.1148 0.3183 0.101315
1929 -0.0891 0.1148 -0.2039 0.041575
1930 -0.2526 0.1148 -0.3674 0.134983
Sum: 0.5741 Sum 0.343677

Variance (σ2): 0.085919

Average: 0.11482 Standard Deviation: 0.29312

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Historical Returns, Standard Deviations, and

Frequency Distributions: 1926—2012

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Why Does a Risk Premium Exist?

The Second Lesson: The greater the return

variability (i.e. the greater the risk), the
greater the potential reward.

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Normal Distribution
• Does a normal distribution describe asset returns?

 For random set of returns, it will be useful to describe the probability of

ending up in a given range of returns.

• By using both the average return and the STD deviation, we can find out
and describe the probability of ending up in a given range. In other words,
we will be able to know the probability that a particular return fall in a
particular range of returns.

• Normal distribution: A symmetric, bell-shaped frequency distribution that

can be described with only an average and a standard deviation.

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Frequency Distribution of Returns on

Common Stocks, 1926—2012

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The Normal Distribution and

Large Company Stock Returns
• To figure out the probability,
there are there conventional
values of probability of three
ranges:
• - with 1σ of the average, the
range will be μ± 1σ, and the
prob. that a given return will be in
this range is 68%.
• - with 2σ of the average, the
range will be μ± 2σ, and the
prob. that a given return will be in
this range is 95%.
• - with 3σ of the average, the
range will be μ± 3σ, and the
prob. that a given return will be in
this range is 99%.

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Arithmetic Averages versus

Geometric Averages

More on return calculations

Arithmetic Average Geometric Average

“What was your return in an average year “What was your average compound
over a particular period?” return per year over a particular period?”

When we talk about average returns, we generally are talking

about arithmetic average returns.

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Arithmetic Averages versus

Geometric Averages
• Note that the way to calculate the arithmetic average is the same as the
way to calculate the average returns.

• So, what we need to learn is how to calculate a geometric average.

• Suppose we have N years of returns, then:

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Example: Calculating a
Geometric Average Return
• Let’s use the large-company stock data from Table 1.1.
• The spreadsheet below shows us how to calculate the geometric average
return.

• Approximation:
 Geometric Avg. =

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Example: Calculating a
Geometric Average Return
• Let’s use the large-company stock data from Table 1.1.
• The spreadsheet below shows us how to calculate the geometric
average return.

• Approximation:
Geometric Avg. =

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Geometric versus Arithmetic Averages,

1926—2012

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Arithmetic Averages versus

Geometric Averages
• Remember that:
- The arithmetic average tells you what you earned in a typical year.

- The geometric average tells you what you actually earned per year on
average, compounded annually.

• For the purpose of forecasting future returns:

― The arithmetic average is probably "too high" for long forecasts.
― The geometric average is probably "too low" for short forecasts.

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Arithmetic Averages versus

Geometric Averages (Cont.)
• To solve this problem, the two averages are combined in Blume’s Formula
to forecasting future returns:

Where N is years of data, and T is T-year average returns forecasts.

Example: for 81 years, suppose the Geometric average was 10.4% and the
arithmetic average was 12.3%, calculate average return forecasts for 5 and
25 years.

• For T=5, R(T) = 12.2%

• For T=25, R(T) = 11.7%

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Dollar-Weighted Average Returns, I

• There is a hidden assumption we make when we calculate
arithmetic returns and geometric returns.

• The hidden assumption is that we assume that the investor

makes only an initial investment.

• Clearly, many investors make deposits or withdrawals through

time.
- Add money to investments over time to save for retirement.
- Withdraw funds to meet unexpected needs.
- Time the market; adding funds because investments will soon increase in their
value, Sell part of their investments before an anticipate decline.

• How do we calculate returns in these cases?

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Dollar-Weighted Average Returns, II

• The relevant return measurement in this case is Dollar weighted
average return.
• You had returns of 10% in year one and -5% in year two.
• If you only make an initial investment at the start of year one:
― The arithmetic average return is 2.50%.
― The geometric average return is 2.23%.
• Suppose you makes a $1,000 initial investment and a $4,000 additional
investment at the beginning of year two.
― At the end of year one, the initial investment grows to $1,100.
― At the start of year two, your account has $5,100.
― At the end of year two, your account balance is $4,845.
― You have invested $5,000, but your account value is only $4,845.

• So, the (positive) arithmetic and geometric returns are not correct.
• To find DWAR, we need to find the average rate of return that equates the cash
outflows to our cash inflows. This known as IRR.
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Dollar-Weighted Average Returns and IRR

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Risk and Return

• If you are unwilling to bear risk, then you can earn risk-free rate.

• The risk-free rate represents compensation for just waiting.

• Therefore, this is often called the time value of money.

• BUT, If you are willing to bear risk, then we can expect to earn a risk premium,
at least on average.
• Thus, the more risk we are willing to bear, the greater the expected risk
premium.
• Risk premium is a compensation for worrying

Investment has two components

Wait Worry
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Historical Risk and Return Trade-Off

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A Look Ahead

• This text focuses exclusively on financial assets: stocks, bonds, options, and
futures.

• You will learn how to value different assets and make informed, intelligent
decisions about the associated risks.

• You will also learn about different trading mechanisms, and the way that
different markets function.

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Useful Internet Sites

• finance.yahoo.com (reference for a terrific financial web site)

• www.globalfinancialdata.com (reference for historical financial market data—

not free)

• www.robertniles.com/stats (reference for easy to read statistics review)

• jmdinvestments.blogspot.com (reference for recent financial information)

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Chapter Review, I

• We Calculate Returns Using Several Methods

• The Historical Record

―A First Look
―A Longer Range Look
―A Closer Look

• Average Returns: The First Lesson

―Calculating Average Returns
―Average Returns: The Historical Record
―Risk Premiums

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Chapter Review, II

• Return Variability: The Second Lesson

―Frequency Distributions and Variability
―The Historical Variance and Standard Deviation
―The Historical Record
―Normal Distribution

• Arithmetic Returns versus Geometric Returns

• Dollar Weighted Average Returns

• The Risk-Return Trade-Off

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