1 AN INTRODUCTION TO RISK AND RETURN Chapter 7 Learning Objectives 2 Calculate realized and expected rates of return 1. and risk. Describe the historical pattern of financial market 2. returns. Compute geometric (or compound) and arithmetic 3. average rates of return. Explain the efficient market hypothesis and why it 4. is important to stock prices. Principles Applied in This Chapter 3 Principle 2: There is a Risk-Return Tradeoff. Principle 4: Market Prices Reflect Information. 1
Calculating the Realized Return from an Investment 4 Realized return or cash return measures the gain or loss on an investment. Example: You invested in 1 share of Apple (AAPL) for $95 and sold a year later for $200. The company did not pay any dividend during that period. What will be the cash return on this investment? Calculating the Realized Return from an Investment 5 Suppose you buy a share for $95. It pays no dividend. After 1 year you sell it for $200 Cash Return = $200 + 0 - $95 = $ 1 0 5 Calculating the Realized Return from an Investment 6 Percentage return cash return divided by the beginning stock price. Rate of Return = ($200 + 0 - $95) ÷ 95 = 1 1 0 .5 3 % 2
Calculating Realized Rate of Return 7 Calculating the Expected Return from an Investment 8 Expected return is what the investor expects to earn from an investment in the future. Table 7 -2 Calculating the Expected Rate of Return for an Investment in Common Stock 9 3
Measuring Risk 10 The variability in returns can be quantified by computing the Variance or Standard Deviation in investment returns. The formula for the variance is � � � �� � � μ� � � � � �� � � μ� � � � � … � �� � � μ� � � � The standard deviation is � � √� � 11 • Expected Return, E(r) = 0.15 • Variance = 0.0165 • Standard Deviation = 0.1285 A Brief History of the Financial Markets 12 Investors have historically earned higher rates of return on riskier investments. However, having a higher expected rate of return simply means that investors “expect” to realize a higher return. Higher return is not guaranteed. 4
Historical Rates of Return for U.S. Financial Securities: 1926–2011 13 Historical Rates of Return, 1970-2015 14 Stocks, Bonds, Commodities, and Real Estate 15 5
Stocks, Gold and Real Esate 16 Figure 7.4 Historical Rates of Return in Global Markets: 1970–2011 17 Figure 7.5 Investing in Emerging Markets: 1988– 2011 18 6
Lessons Learned 19 Lesson # 1: The riskier investments have historically realized higher returns. Lesson # 2: The historical returns of the higher-risk investment classes have higher standard deviations. Geometric vs. Arithmetic Average Rates of Return 20 “What was the average of the yearly rates of return?” The arithmetic average rate of return answers the question “What was the growth rate of your investment?” The geometric average rate of return answers the question Choosing the Right “Average” 21 Both arithmetic average geometric average are important and correct. The following grid provides some guidance as to which average is appropriate and when: Question being addressed: Appropriate Average Calculation: What annual rate of return The arithmetic average rate can we expect for next year? of return calculated using annual rates of return. What annual rate of return The geometric average rate of can we expect over a multi- return calculated over a year horizon? similar past period. 7
Computing the Geometric Average Rate of Return 22 Compute the arithmetic and geometric average for the following stock. Computing Geometric Average Rate of Return 23 Arithmetic Average = (40+ (-50)) ÷ 2 = -5 % Geometric Average = [ (1+ R year1 ) × (1+ R year 2 )] 1/ 2 - 1 = [ (1.4) × (1+ (-.5))] 1/ 2 - 1 = -1 6 .3 3 % Computing Rates of Return 24 What are the arithmetic and geometric rates of return? 8
What Determines Stock Prices 25 The value of an asset is the expected present value to the future cash flows. For stocks, the future cash flows come from Dividends Price appreciation Efficient Market Hypothesis 26 The efficient m arket hypothesis ( EMH) states that securities prices accurately reflect future expected cash flows and are based on all information available to investors. An efficient m arket is a market in which all the available information is fully incorporated into the prices of the securities and the returns the investors earn on their investments cannot be predicted. The Efficient Market Hypothesis 27 The w eak-form efficient m arket 1. hypothesis The sem i-strong form efficient m arket 2. hypothesis The strong-form efficient m arket 3. hypothesis 9
Efficient Market Hypothesis 28 Public & Private Info Public Info Transaction Info Do We Expect Financial Markets To Be Perfectly Efficient ? 29 In general, markets are expected to be at least weak-form and semi-strong form efficient. If there did exist simple profitable strategies, then the strategies would attract the attention of investors, who by implementing their strategies would compete away the profits. The Behavioral View 30 Efficient market hypothesis is based on the assumption that investors, as a group, are rational. This view has been challenged. If investors do not rationally process information, then markets may not accurately reflect even public information. 10
Table 7 -4 Summarizing the Evidence of Anomalies to the Efficient Market Hypothesis 31 11
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