Because learning changes everything.

Chapter 10
Some Lessons from
Capital Market History

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
 Key Concepts and Skills
After studying this chapter, you should be able to:
• Calculate the return on an investment.
• Discuss the historical returns on various types of
investments.

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• Explain the historical risks on various types of investments.
• Assess the implications of market efficiency.

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 Chapter Outline
10.1 Returns.
10.2 The Historical Record.
10.3 Average Returns: The First Lesson.
10.4 The Variability of Returns: The Second Lesson.
10.5 More on Average Returns.
10.6 Capital Market Efficiency.

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 Risk-Return Trade-off FEF

Two key lessons from capital market history:

• There is a reward for bearing risk.
• The greater the potential reward, the greater the risk.

ATIERA required return (R) #

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,

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 Dollar & Percent Returns
EXTREM
Total dollar return = Return on an investment measured in

I
dollars.
At
• Dollar return = Dividends + Capital gains.
VS
. • Capital gains = Price received − Price paid.
E x

Total percent return = the return on an investment measured

as a percentage of the original investment.
• Percent return = Dollar return/Dollar invested.
FAREBETH

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 Percent Return
-=
n

Dt +1
DY Dividend Yield → DY = -

Pt
FRABE EFP'i -STEPS
+
~

>
Capital Gains Yield → Pt +1 − Pt
CGY CGY =
= 145 Pt
% Return = DY + CGY
-

Dt +1 + Pt +1 − Pt
%Return =
Pt

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 Example: Calculating Total Dollar and Total
Percent Returns
You invest in a stock with a share price of $25. X Pe

After one year, the stock price per share is $35. - Pet

Each share paid a $2 dividend. >

- AB) De +
35 25
t
2+ -

What was your total return?

=

25

Dollars
Dollars Percent
Percent
Dividend $2.00 $2/$25 = .40,
=> or 40% 8%

Capital Gain $35 − 25 = $10 $10/$25 = .40, or 40%

Total Return $2 + 10 = $12 $12/$25 = .48, or 48%
D+ + 1 + Pt + 1
-

Pt
% Return = =
Dy + CGY
Pt

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 U.S. Financial Markets
Figure 10.4 A $1 investment in different types of portfolios: December 31,
1925 to December 31, 2020 (year-end 1925 = $1)

Source: 2021 SBBI Yearbook, Duff & Phelps.

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 Year-to-Year Total Returns 1

Large-Company Stock Returns

Figure 10.5 Year-to-year total returns on large-company stocks: 1926 to
2020

Source: 2021 SBBI Yearbook, Duff & Phelps.

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 Year-to-Year Total Returns 2

Small-Company Stock Returns

Figure 10.6 Year-to-year total returns on small-company stocks: 1926 to
2020

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Source: 2021 SBBI Yearbook, Duff & Phelps.

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 Year-to-Year Total Returns 3

Long-Term Government Bonds & U.S. Treasury Bills Returns

Figure 10.7 Year-to-year total returns on bonds and bills: 1926 to 2020

Source: 2021 SBBI Yearbook, Duff & Phelps.

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 Year-to-Year Inflation
Year-to-Year Percentage Change in the CPI
Figure 10.8 Year-to-year inflation: 1926 to 2020

Source: 2021 SBBI Yearbook, Duff & Phelps.

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 Average Returns: The First Lesson 1926 to
2020
Table 10.2

Investment
Investment Average Return
Average Return
Large stocks 12.2%
Small stocks MIA 16.2
~
*F
Long-term corporate bonds 6.5
Long-term government bonds 6.1
U.S. Treasury bills 3.3
Inflation 2.9
Source: 2021 SBBI Yearbook, Duff & Phelps.

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 Historical Average Returns
Historical Average Return = Simple, or arithmetic average.
T

∑ yearly return
i =1
Historical Average Return =
T
Using the data in Table 10.1:
• Sum the returns for large-company stocks from 1926
through 2020, you get about 11.55/95 years = .122, or 12.2%.

Your best guess about the size of the return for a year
selected at random is 12.2 percent.

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 Risk Premiums APEA
>
-

AAFFEATEPHilaEt FREE Excess Return

Risk-free rate:
#* eX E.

• Rate of return on a riskless investment.

• Treasury Bills are considered risk-free.
FAG #B BERM
Risk premium: Rt-Rf↑
Risk premium (RP)
=
=

Expect return (ER)

• Excess return on a risky asset over the risk-free rate.
• Reward for bearing risk.

© McGraw Hill, LLC 16

 Historical Risk Premiums

Large Stocks
Large Stocks: = 12.2%
12 , % − 3.3%
2
-

3 3 % = 8.9%
.
= 8 9.

Small Stocks: 16.2% − 3.3% = 12.9%

-

L/T Corporate Bonds: 6.5% − 3.3% = 3.2%

L/T Government Bonds: 6.1% − 3.3% = 2.8%
U.S. Treasury Bills: It 3.3% − 3.3% = 0*
-

* By definition!
Table 10.3

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 Risk EMTB9 FRE
Risk is measured by the dispersion, spread, or volatility of returns.
Figure 10.9 Frequency distribution of returns on common stocks:
1926 to 2020 * Return rate #FL

range X A
#AEEFEE]

*
#Ra &2
=> AT

Source: 2021 SBBI Yearbook, Duff & Phelps.

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 Return Variability Review FEEK
VAR o
.

Variance = VAR(R) or σ 2 . * F T
• Common measure of return dispersion.
• Also call variability.

Standard deviation = SD(R) or σ . *

• Square root of the variance.
• Sometimes called volatility.
• Same “units” as the average.

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 Return Variability: The Statistical Tools for
Historical Returns
Return variance: (“T” = number of returns).
T 2
∑ (R − R )
i
VAR (R ) = σ 2 = i =1

T −1
Standard deviation:

SD (R ) = σ VAR (R )

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 Example: Calculating Historical Variance and
Standard Deviation
Using data from Table 10.1 for large-company stocks:

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

Average Difference: Squared:
Year Return Return: (2) − (3) (4) × (4)
1926 11.62 11.88 −.26 .07
1927 37.49 11.88 25.61 655.87
1928 43.61 11.88 31.73 1,006.79
1929 −8.42 11.88 −20.30 412.09
1930 −24.90 11.88 −36.78 1,352.77
Sum: 59.40
Average: 11.88 Variance: 856.90
Sum: 3,427.59

Standard Deviation: ~
29.27 A

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 Example: Work the Web
How volatile are mutual funds?
Morningstar provides information on mutual funds, including
volatility (standard deviation).
Click on this link to go to the Morningstar site.
• Pick a fund, such as the Fidelity Magellan (FMAGX).
a

• Enter the ticker in the “Stock/Fund” box, click on the “Go”

button, and then click on “Ratings & Risk.”

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 Historical Average Returns and Standard
Deviations Figure 10.10 PRIN
1

Figure 10.10 Historical average returns, standard deviations, and frequency distributions:
1926 to 2020
T
*F
Arithmetic Standard
Series Mean (%) Deviation (%) Distribution (%)
Small-company stocks* 16.2 31.3 K

Large-company stocks 12.2 19.7

Long-term corporate bonds 6.5 8.5

Long-term government bonds 6.1 9.8

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 Historical Average Returns and Standard
Deviations Figure 10.10 2

Arithmetic Standard
Series Mean (%) Deviation (%) Distribution (%)
Intermediate-term government 5.3 5.6
bonds

U.S. Treasury bills 3.3 3.1

Inflation 2.9 4.0

* The 1933 small-company stocks total return was 142.9 percent.

Source: 2021 SBBI Yearbook, Duff & Phelps.

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 Return Variability Review and Concepts
Normal distribution:
• A symmetric frequency distribution.
• The “bell-shaped curve.”
• Completely described by the mean and variance.
Does a normal distribution describe asset returns?

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 The Normal Distribution Figure 10.11
Figure 10.11 The normal distribution Illustrated returns are based on the
historical return and standard deviation for a portfolio of large common stocks.

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 Record One-Day Losses
Top 12 One-Day Percentage Changes in the
Dow Jones Industrial Average
1 October 19, 1987 −22.61
2 March 16, 2020 −12.93
3 October 28, 1929 −12.82
4 October 29, 1929 −11.73
5 March 12, 2020 −9.99
6 November 6, 1929 −9.92
7 December 18, 1899 −8.72
8 August 12, 1932 −8.40
9 March 14, 1907 −8.29
10 October 26, 1987 −8.04
11 October 15, 2008 −7.87
12 July 21, 1933 −7.84
Source: https://en.wikipedia.org/wiki/List_of_largest_daily_changes_in_the_Dow_Jones_Industrial_Average April 23, 2021.

© McGraw Hill, LLC 27

 2008: The Bear Growled and Investors Howled

The S&P 500 lost 50 percent of its value from November

2007 through March 2009.
• On the other hand, long-term Treasuries gained 40 percent
during 2008.
A global phenomenon.
Volatile in both directions.
• The S&P 500 doubled in value from March 2009 through
February 2011.

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 2008: S&P 500 Monthly Returns
Figure 10.12 S&P 500 monthly returns: 2008

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 Arithmetic versus Geometric Mean
Arithmetic average: ]
• Return earned in an average period over multiple periods.
• Answers the question: “What was your return in an average
year over a particular period?”
Geometric average: M4t7
• Average compound return per period over multiple periods.

&
• Answers the question: “What was your average compound
return per year over a particular period?”
Geometric average < Arithmetic average unless all the
returns are equal.

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 ME
Geometric Average Return: Formula
Equation 10.4 * A

2 M +E & FAMway
TEM
1/T ↑

DGeometric average return = ⎡ (1 + R1) (

× 1 + R2)× !× (1 + RT ) − 1⎤
⎣ -
u
⎦
& MPREH =
(I + R >X (HR1) X
, x
(HRi)
Where:
...

RT = Return in each period.

T = Number of periods.

© McGraw Hill, LLC 31

 Example: Calculating a Geometric Average
Return Example 10.4
Percent Compounded
compounded
Year Percent Return
Return PlusPlus
OneOne Return
Return Return:
Return
1926 11.14 1.1114 1.1114
In the following table, read ‘1.4870(1/5)’ as 1.4870 to the power 1 over 5.

1927 37.13 1.3713 1.5241

1928 43.31 1.4331 2.1841
1929 −8.91 0.9109 1.9895
1930 −25.26 0.7474 1.4870

↓ 1.4870(1/5): 1.0826
R + 7 Geometric Average Return:
:
8.26%
5
1-1114 x 113713 x .. xQ414 =
1 -
0826

© McGraw Hill, LLC 32

 Geometric Average Return 2

Percent Compounded
Year % Return
Return One Plus Return Return:
1926 11.14 1.1114 1.1114
In the following table, read ‘1.4870(1/5)’ as 1.4870 to the power 1 over 5.

1927 37.13 1.3713 1.5241

1928 43.31 1.4331 2.1841
1929 −8.91 0.9109 1.9895
1930 −25.26 0.7474 1.4870
1.4870(1/5): 1.0826
N 5 * th Average Return:
Geometric 8.26%
I/Y CPT = 8.26%
PV −$1.0000
Fr = PrcI + ry
PMT 0
FV $1.4870
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 Historical Geometric versus Arithmetic
Average Returns
Table 10.4 Geometric versus Arithmetic Average Returns: 1926 to 2020
MFt] <FitE
LATr]
Average Return Average Return
The
Series Geometric Arithmetic Standard Deviation
Large-company stocks 10.3% 12.2% 19.7%
Small-company stocks 11.9 16.2 31.3
&

Long-term corporate 6.2 6.5 8.5

bonds
Long-term government 5.7 6.1 9.8
bonds
Intermediate-term 5.1 5.3 5.6
government bonds
U.S. Treasury bills 3.3 3.3 3.1
Inflation 2.9 2.9 4.0

© McGraw Hill, LLC 34

 Arithmetic versus Geometric Mean Which
is better?
E #FAR-
D
The arithmetic average is overly optimistic for long horizons.
TheO geometric average is overly pessimistic for short
horizons. it ELAR

Depends on the planning period under consideration.

• 15 to 20 years or less: use the arithmetic. *** (EA)
• 20 to 40 years or so: split the difference between them.
• 40 + years: use the geometric. #E (ESA)

> MEGtE ↓
Y

& JER R

© McGraw Hill, LLC 35

 Efficient Capital Markets
The Efficient Market Hypothesis:
• Stock prices are in equilibrium. +5 ( ) =

• Stocks are “fairly” priced. X

• Informational efficiency.
* E
If true, you should not be able to earn “abnormal” or “excess”
returns. is

Efficient markets DO NOT imply that investors cannot earn a

positive return in the stock market.

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 Reaction of Stock Price to New Information in
Efficient and Inefficient Markets Figure 10.14
Figure 10.14 Reaction of stock price to new information in efficient and
inefficient markets

&t AREE--E
RI - LE REFE ZE
. .

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 Forms of Market Efficiency ipt,

Strong Form Efficient Market: 3

• Information = public or private. FER A ,

• →“Inside information” is of little use.

Semistrong Form Efficient Market: #32t

• Information = publicly available information. #F
• → Fundamental analysis is of little use. F . FRE .

Weak Form Efficient Market: E

• Information = past prices and volume data.
• → Technical analysis is of little use. H E FIT
2x-*** #5 FA # : IE
. ...

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 Strong Form Efficiency
Prices reflect all information, including public and private.
If true, then investors cannot earn abnormal returns
regardless of the information they possess.
Empirical evidence indicates that markets are NOT strong
form efficient.
• Insiders can earn abnormal returns (may be illegal).

© McGraw Hill, LLC 39

 Semistrong Form Efficiency
Prices reflect all publicly available information including
trading information, annual reports, press releases, etc.
If true, then investors cannot earn abnormal returns by
trading on public information.
Implies that fundamental analysis will not lead to abnormal
returns.

© McGraw Hill, LLC 40

 Weak Form Efficiency
Prices reflect all past market information such as price and
volume.
If true, then investors cannot earn abnormal returns by
trading on market information.
Implies that technical analysis will not lead to abnormal
returns.
Empirical evidence indicates that markets are generally weak
form efficient.

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 Efficient Market Hypotheses

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 Common Misconceptions about EMH
EMH does not mean that you cannot make money.
EMH does mean that:
• On average, you will earn a return appropriate for the risk
undertaken.
• There is no bias in prices that can be exploited to earn
excess returns.
• Market efficiency will not protect you from wrong choices if
you do not diversify—you still do not want to put all your
eggs in one basket.

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