Chapter 12 dw
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This document discusses lessons from capital market history including the risk-return tradeoff where greater potential reward comes with greater risk. It provides data on average historical returns for different asset classes as well as risk premiums. It also discusses efficient capital markets and the forms of market efficiency. The key points are that there is a reward for bearing risk, historical returns have been higher for small stocks and stocks in general provide higher returns than bonds but also carry more risk, and that market prices reflect all available public information according to the efficient market hypothesis.
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Chapter 12 dw
- 1. © 2003 The McGraw-Hill Companies, Inc. All rights reserved. Some Lessons From Capital Market History Chapter Twelve
- 2. Risk, Return and Financial Markets • Lesson from capital market history – There is a reward for bearing risk – The greater the potential reward, the greater the risk – This is called the risk-return trade-off • Total dollar return = income from investment + capital gain (loss) due to change in price
- 3. FIGURE 12.4
- 4. Average Returns Investment Average Return Large stocks 13.0% Small Stocks 17.3% Long-term Corporate Bonds 6.0% Long-term Government Bonds 5.7% U.S. Treasury Bills 3.9% Inflation 3.2%
- 5. Risk Premiums • The “extra” return earned for taking on risk • Treasury bills are considered to be risk-free • The risk premium is the return over and above the risk-free rate
- 6. Historical Risk Premiums • Large stocks: 13.0 – 3.9 = 9.1% • Small stocks: 17.3 – 3.9 = 13.4% • Long-term corporate bonds: 6.0 – 3.9 =2.1% • Long-term government bonds: 5.7 – 3.9 = 1.8%
- 7. Variance and Standard Deviation • Variance and standard deviation measure the volatility of asset returns • The greater the volatility the greater the uncertainty • Historical variance = sum of squared deviations from the mean / (number of observations – 1) • Standard deviation = square root of the variance
- 8. FIGURE 12.10
- 9. FIGURE 12.11
- 10. Efficient Capital Markets • Stock prices are in equilibrium or are “fairly” priced • If this is true, then you should not be able to earn “abnormal” or “excess” returns • Efficient markets DO NOT imply that investors cannot earn a positive return in the stock market
- 11. FIGURE 12.12
- 12. What Makes Markets Efficient? • There are many investors out there doing research – As new information comes to market, this information is analyzed and trades are made based on this information – Therefore, prices should reflect all available public information • If investors stop researching stocks, then the market will not be efficient
- 13. Common Misconceptions about EMH • Efficient markets do not mean that you can’t make money • They do mean that, on average, you will earn a return that is appropriate for the risk undertaken and there is not a 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 don’t want to put all your eggs in one basket
- 14. Strong Form Efficiency • Prices reflect all information, including public and private • If the market is strong form efficient, then investors could not earn abnormal returns regardless of the information they possessed • Empirical evidence indicates that markets are NOT strong form efficient and that insiders could earn abnormal returns
- 15. Semistrong Form Efficiency • Prices reflect all publicly available information including trading information, annual reports, press releases, etc. • If the market is semistrong form efficient, then investors cannot earn abnormal returns by trading on public information • Implies that fundamental analysis will not lead to abnormal returns
- 16. Weak Form Efficiency • Prices reflect all past market information such as price and volume • If the market is weak form efficient, 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
Editor's Notes
- Ask the students to think about why the different investments have different risk premiums.
- Point out that one consequence of the wider availability of information and lower transaction costs is that the market will be more volatile. It is easier to trade on “small” news instead of just big events. It is also important to remember that not all available information is reliable information. It’s important to still do the research and not just jump on everything that crosses the news wire. The case of Emulex, discussed earlier, is an excellent example.
- Students are often very interested in insider trading. See the IM for a more detailed discussion.
- Empirical evidence suggests that some stocks are semistrong form efficient, but not all. Larger, more closely followed stocks are more likely to be semistrong form efficient. Small, more thinly traded stocks may not be semistrong form efficient but liquidity costs may wipe out any abnormal returns that are available.
- Emphasize that just because technical analysis shouldn’t lead to abnormal returns, that doesn’t mean that you won’t earn fair returns using it – efficient markets imply that you will. You might also want to point out that there are many technical trading rules that have never been empirically tested; so it is possible that one of them might lead to abnormal returns. But if it is well publicized, then any abnormal returns that were available will soon evaporate.