Risk and Return

PART 1
chapter
A Brief History of
Risk and Return
1
“All I ask is for the chance to prove that money can’t make me happy.”
+ Learning
Objectives
To become a wise
–Spike Milligan
investor (maybe even one

Who wants to be a millionaire? Actually, anyone can retire as a millionaire. How?
with too much money), Consider this: Suppose you, on your 25th birthday, invest $3,000. You have the discipline
you need to know:
to invest $3,000 on each of your next 39 birthdays until you retire on your 65th birthday.
1. How to calculate How much will you have? The answer might surprise you. If you earn 10 percent
the return on
an investment per year, you will have about $1.46 million. Are these numbers realistic? Based on the
using different history of financial markets, the answer appears to be yes. For example, over the last
methods.
90 or so years, the widely followed Standard & Poor’s Index of large-company common
2. The historical
stocks has actually yielded about 12 percent per year.
returns
on various
important types
of investments.
The study of investments could begin in many places. After thinking it over, we decided
3. The historical that a brief history lesson is in order, so we start our discussion of risk and return by look-
risks on various ing back at what has happened to investors in U.S. financial markets since 1925. In 1931,
important types for example, the stock market lost 43 percent of its value. Just two years later, the market
of investments. reversed itself and gained 54 percent. In more recent times, the stock market lost about
4. The relationship 25 percent of its value on October 19, 1987, alone, and it gained almost 40 percent in 1995.
between risk and From 2003 through 2007, the market gained about 80 percent. In 2008, the market fell
return. almost 40 percent. In 2009, the market reversed course again, and through 2015 the market
CFA™ Exam Topics in this Chapter:

1. Discounted cash flow applications (L1, S2)
2. Statistical concepts and market returns (L1, S2)
3. Common probability distributions (L1, S3)
4. Sampling and estimation (L1, S3)
5. Dividend and share repurchases: Analysis (L2, S8)
6. Evaluating portfolio performance (L3, S17)
Go to Connect for a guide that aligns your textbook with CFA readings.
recovered from its large losses (and more), as the return over this seven-year period was
over 150 percent.
So what should you, as a stock market investor, expect when you invest your own money?
In this chapter, we study more than eight decades of market history to find out.
In this chapter, we present the historical relation between risk and return. As you will
see, this chapter has a lot of very practical information for anyone thinking of investing in
financial assets such as stocks and bonds. For example, suppose you were to start investing in
stocks today. Do you think your money would grow at an average rate of 5 percent per year?
Or 10 percent? Or 20 percent? This chapter gives you an idea of what to expect (the answer
may surprise you). The chapter also shows how risky certain investments can be, and it gives
you the tools to think about risk in an objective way.
Our primary goal in this chapter is to see what financial market history can tell us about
risk and return. Specifically, we want to give you a perspective on the numbers. What is
a high return? What is a low return? More generally, what returns should we expect from
financial assets such as stocks and bonds, and what are the risks from such investments?
Beyond this, we hope that by studying what did happen in the past, we will at least gain some
insight into what can happen in the future.
The history of risk and return is made day by day in global financial markets. The Internet
is an excellent source of information on financial markets. Visit our website within Connect
for suggestions on where to find information on recent financial market events. We will
suggest other sites later in the chapter.
Not everyone agrees on the value of studying history. On the one hand, there is phi-
losopher George Santayana’s famous comment, “Those who do not remember the past are
condemned to repeat it.” On the other hand, there is industrialist Henry Ford’s equally
famous comment, “History is more or less bunk.” These extremes aside, perhaps everyone
would agree with Mark Twain, who observed, with remarkable foresight (and poor gram-
mar), that “October. This is one of the peculiarly dangerous months to speculate in stocks
in. The others are July, January, September, April, November, May, March, June, December,
August, and February.”
Two key observations emerge from a study of financial market history. First, there
is a reward for bearing risk, and at least on average, that reward has been substantial.
That’s the good news. The bad news is that greater rewards are accompanied by greater risks.
The fact that risk and return go together is probably the single most important fact to under-
stand about investments, and it is a point to which we will return many times.
1.1 Returns
We wish to discuss historical returns on different types of financial assets. First, we need
to know how to compute the return from an investment. We will consider buying shares of
stock in this section, but the basic calculations are the same for any investment.
DOLLAR R E TUR N S
If you buy an asset of any type, your gain (or loss) from that investment is called the
return on your investment. This return will usually have two components. First, you may
receive some cash directly while you own the investment. Second, the value of the asset
you purchase may change. In this case, you have a capital gain or capital loss on your
investment.1
To illustrate, suppose you purchased 200 shares of stock in Harley-Davidson (ticker
symbol: HOG) on January 1. At that time, Harley was selling for $50 per share, so your
200 shares cost you $10,000. At the end of the year, you want to see how you did with
your investment.
1
As a practical matter, what is and what is not a capital gain (or loss) is determined by the Internal Revenue
Service. Even so, as is commonly done, we use these terms to refer to a change in value.
2 Part 1 Introduction
The first thing to consider is that over the year, a company may pay cash dividends to its
shareholders. As a stockholder in Harley, you are a part owner of the company, and you are
entitled to a portion of any money distributed. So if Harley chooses to pay a dividend, you
will receive some cash for every share you own.
In addition to the dividend, the other part of your return is the capital gain or loss on
the stock. This part arises from changes in the value of your investment. For example,
consider these two cases:
Case 1 Case 2
Ending Stock Price $ 55.60 $ 39.80
January 1 value 10,000 10,000
December 31 value 11,120 7,960
Dividend income 80 80
Capital gain or loss 1,120 −2,040
At the beginning of the year, on January 1, the stock was selling for $50 per share.
As we calculated above, your total outlay for 200 shares is $10,000. Over the year,
Harley paid dividends of $0.40 per share. By the end of the year, then, you received
dividend income of
Dividend income = $0.40 × 200 = $80
In Case 1, suppose that as of December 31, a HOG share was selling for $55.60, meaning
that the value of your stock increased by $5.60 per share. Your 200 shares would be worth
$11,120, so you have a capital gain of
Capital gain = ($55.60 − $50) × 200 = $1,120
On the other hand, if the price had dropped to, say, $39.80 (Case 2), you would have a
capital loss of
Capital loss = ($39.80 − $50) × 200 = −$2,040
Notice that a capital loss is the same thing as a negative capital gain.
total dollar return The total dollar return on your investment is the sum of the dividend income and
The return on an investment the capital gain (or loss):
measured in dollars that
accounts for all cash flows and Total dollar return = Dividend income + Capital gain (or loss)
capital gains or losses.
In Case 1, the total dollar return is thus given by
Total dollar return = $80 + $1,120 = $1,200
Overall, between the dividends you received and the increase in the price of the stock,
the value of your investment increased from $10,000 to $10,000 + $1,200 = $11,200.
A common misconception often arises in this context. Suppose you hold on to your
Harley-Davidson stock and don’t sell it at the end of the year. Should you still consider the
capital gain as part of your return? Isn’t this only a “paper” gain and not really a cash gain
if you don’t sell it?
The answer to the first question is a strong yes, and the answer to the second is an equally
strong no. The capital gain is every bit as much a part of your return as the dividend, and you
should certainly count it as part of your return. The fact that you decide to keep the stock and
don’t sell (you don’t “realize” the gain) is irrelevant because you could have converted it to
cash if you had wanted to. Whether you choose to do so is up to you.
After all, if you insist on converting your gain to cash, you could always sell the stock
and immediately reinvest by buying the stock back. There is no difference between doing
Chapter 1 A Brief History of Risk and Return3

this and just not selling (assuming, of course, that there are no transaction costs or tax con-
sequences from selling the stock). Again, the point is that whether you actually cash out
and buy pizzas (or whatever) or continue to hold the investment doesn’t affect the return
you actually earn.
P ERCEN TAGE R E TUR N S

It is usually more convenient to summarize information about returns in percentage terms
than in dollar terms because that way your return doesn’t depend on how much you actually
invested. With percentage returns the question we want to answer is: How much do we get
for each dollar we invest?
To answer this question, let Pt be the price of the stock at the beginning of the year.
Let Dt + 1 be the dividend paid on the stock during the year. The following cash flows are
the same as those shown earlier, except that we have now expressed everything on a
per-share basis:
Case 1 Case 2
January 1 stock price, Pt $50.00 $50.00
December 31 stock price, Pt + 1 55.60 39.80
Dividend income, Dt + 1 0.40 0.40
Capital gain or loss 5.60 −10.20
Our favorite investments

In our example, the price at the beginning of the year was $50 per share and the dividend
website is Yahoo! paid during the year on each share was $0.40. If we divide the dividend by the beginning
Finance at stock price, the result is the dividend yield:
finance.yahoo.com.
Visit this site and look Dividend yield = Dt + 1 /Pt(1.1)
around!
= $0.40 / $50 = 0.0080 = 0.80%
This calculation says that for each dollar we invested, we received 0.80 cents in dividends.
dividend yield The second component of our percentage return is the capital gains yield. This yield
The annual stock dividend as a
is calculated as the change in the price during the year (the capital gain) divided by the
percentage of the initial stock
price. beginning price. With the Case 1 ending price, we get:
capital gains yield Capital gains yield = (Pt + 1 − Pt ) /Pt(1.2)

The change in stock price as a = ($55.60 − $50.00) / $50.00
percentage of the initial stock
= $5.60 / $50 = 0.1120 = 11.20%
price.
This 11.20 percent yield means that for each dollar invested, we got about 11 cents in capital
gains (HOG heaven).
Putting it all together, per dollar invested, we get 0.80 cents in dividends and 11.20 cents
total percent return in capital gains for a total of 12.00 cents. Our total percent return is 12 cents on the dollar,
The return on an investment or 12.00 percent. When a return is expressed on a percentage basis, we often refer to it as the
measured as a percentage that rate of return, or just “return,” on the investment. Notice that if we combine the formulas for
accounts for all cash flows and the dividend yield and capital gains yield, we get a single formula for the total percentage
capital gains or losses. return:
Percentage return = Dividend yield + Capital gains yield(1.3)

= Dt + 1 /Pt + (Pt + 1 − Pt ) /Pt
= (Dt + 1 + Pt + 1 − Pt ) /Pt
To check our calculations, notice that we invested $10,000 and ended up with $11,200.
By what percentage did our $10,000 increase? As we saw, our gain was $11,200 −
$10,000 = $1,200. This is an increase of $1,200/$10,000, or 12.00 percent.
+ WORK THE WEB
To look up information on common stocks using the Web, you As you can see, we get the price for each stock, along with
need to know the “ticker” symbol for the stocks in which you information about the change in price and volume (number of
are interested. You can look up ticker symbols in many places, shares traded). You will find a lot of links to hit and learn more,
including one of our favorite sites, finance.yahoo.com. Here we so have at it!
have looked up (using the “Symbol Lookup” link) and entered
ticker symbols for some well-known “tech” stocks: Apple,
Google, Intel, and Microsoft. This is what we got:
EXAMPLE 1.1 Calculating Percentage Returns

Suppose you buy some stock in Concannon Plastics for $35 per share. After one year,
the price is $49 per share. During the year, you received a $1.40 dividend per share.
What is the dividend yield? The capital gains yield? The percentage return? If your total
investment was $1,400, how much do you have at the end of the year?
Your $1.40 dividend per share works out to a dividend yield of
Dividend yield = Dt + 1 /pt
= $1.40 / $35
= 4%
The per-share capital gain is $14, so the capital gains yield is
Capital gains yield = (Pt + 1 − Pt ) /Pt
= ($49 − $35) / $35
= $14 / $35
= 40%
The total percentage return is thus 4% + 40% = 44%.
If you had invested $ 1,400, you would have $ 2,016 at the end of the year.
To check this, note that your $1,400 would have bought you $1,400/$35 = 40 shares.
Your 40 shares would then have paid you a total of 40 × $1.40 = $56 in cash
dividends. Your $14 per share gain would give you a total capital gain of $14 × 40 =
$560. Add these together and you get $616, which is a 44 percent total return on your
$1,400 investment.
A NOTE ON A N N UA L I ZI N G R E TU R N S
So far, we have only considered annual returns. Of course, the actual length of time you own
an investment will almost never be exactly a year. To compare investments, however, we will
usually need to express returns on a per-year or “annualized” basis, so we need to do a little
bit more work.
For example, suppose you bought 200 shares of Cisco Systems (CSCO) at a price of
$30 per share. In three months, you sell your stock for $31.50. You didn’t receive any
dividends. What is your return for the three months? What is your annualized return?

In this case, we say that your holding period, which is the length of time you own
the stock, is three months. With a zero dividend, you know that the percentage return can
be calculated as:
Percentage return = (Pt + 1 − Pt ) /Pt = ($31.50 − $30) / $30 = 0.0500 = 5.00%
This 5.00 percent is your return for the three-month holding period, but what does this
return amount to on a per-year basis? To find out, we need to convert this to an annualized
return, meaning a return expressed on a per-year basis. Such a return is often called an
effective annual return effective annual return, or EAR for short. The general formula is this:
(EAR)
The return on an investment 1 + EAR = (1 + holding period percentage return)m(1.4)
expressed on a per-year, or where m is the number of holding periods in a year.
“annualized,” basis. In our example, the holding period percentage return is 5.00 percent, or 0.0500.
The holding period is three months, so there are four (12 months/3 months) periods in a year.
We calculate the annualized return, or EAR, as follows:
1 + EAR = (1 + holding period percentage return)m
= (1 + 0.0500)4
= 1.2155
So, your annualized return is 21.55 percent.
EXAMPLE 1.2 A “QWEST” for Returns

Suppose you buy some stock in Qwest (no, that’s not a typo; that’s how the company
spells it) at a price of $28 per share. Four months later, you sell for $29.40 per share.
No dividend is paid. What is your annualized return on this investment?
For the four-month holding period, your return is:
Percentage return = (Pt + 1 − Pt ) /Pt = ($29.40 − $28) / $28 = 0.05 = 5%
There are three four-month periods in a year, so the annualized return is:
1 + EAR = (1 + holding period percentage return)m = (1 + 0.05)3 = 1.1576
Subtracting the one, we get an annualized return of 0.1576, or 15.76 percent.
EXAMPLE 1.3 More Annualized Returns

Suppose you buy some stock in Johnson & Johnson (JNJ) at a price of $60 per share.
Three years later, you sell it for $64.50. No dividends were paid. What is your annual-
ized return on this investment?
The situation here is a bit different because your holding period is now longer than
a year, but the calculation is basically the same. For the three-year holding period, your
return is:
Percentage return = (Pt + 1 − Pt ) /Pt = ($64.50 − $60) / $60 = 0.075 = 7.5%
How many three-year holding periods are there in a single year? The answer is one-third,
so m in this case is 1/3. The annualized return is:
1 + EAR = (1 + holding period percentage return)m
= (1 + 0.075)1/3
= 1.0244
Subtracting the one, we get an annualized return of 0.0244, or 2.44 percent.
Now that you know how to calculate returns on a hypothetical stock, you should calculate
returns for real stocks. The nearby Work the Web box using finance.yahoo.com describes
how to begin. Meanwhile, in the next several sections, we will take a look at the returns that
some common types of investments have earned over the last 90 years.
CHECK 1.1a What are the two parts of total return?
THIS 1.1b What is the difference between a dollar return and a percentage return?
Why are percentage returns usually more convenient?
1.1c What is an effective annual return (EAR)?
1.2 The Historical Record

We now examine year-to-year historical rates of return on five important categories of
financial investments. These returns can be interpreted as what you would have earned if
you had invested in portfolios of the following asset categories:
Annual historical 1. Large-company stocks. The large-company stock portfolio is based on the Standard &
financial market data Poor’s (S&P’s) 500 Index, which contains 500 of the largest companies (in terms of
can be downloaded total market value of outstanding stock) in the United States.
(but not for free) at
www.globalfinancialdata.com 2. Small-company stocks. This is a portfolio composed of stock of smaller companies,
where “small” corresponds to the smallest 20 percent of the companies listed on the
New York Stock Exchange, again as measured by market value of outstanding stock.
3. Long-term corporate bonds. This is a portfolio of high-quality bonds with 20 years to
maturity.
4. Long-term U.S. government bonds. This is a portfolio of U.S. government bonds
with 20 years to maturity.
5. U.S. Treasury bills. This is a portfolio of Treasury bills (T-bills for short) with a
three-month maturity.
If you are not entirely certain what these investments are, don’t be overly concerned.
We will have much more to say about each in later chapters. For now, just accept that these
are some important investment categories. In addition to the year-to-year returns on these
financial instruments, the year-to-year percentage changes in the Consumer Price Index
(CPI) are also computed. The CPI is a standard measure of consumer goods price inflation.
We discuss the CPI in more detail in a later chapter.
Here is a bit of market jargon for you. A company’s total market capitalization (or market
“cap” for short) is equal to its stock price multiplied by the number of shares of stock. In other
words, it’s the total value of the company’s stock. Large companies are often called “large-cap”
stocks, and small companies are called “small-cap” stocks. We’ll use these terms frequently.
A FIR ST LOOK
Before examining the different portfolio returns, we first take a look at the “big picture.”
Figure 1.1 shows what happened to $1 invested in these different portfolios at the beginning
of 1926 and held over the 90-year period ending in 2015 (for clarity, the long-term corporate
bonds are omitted). To fit all the information on a single graph, some modification in scaling
is used. As is commonly done with financial time series, the vertical axis is scaled so that
equal distances measure equal percentage (as opposed to dollar) changes in value. Thus, the
distance between $10 and $100 is the same as that between $100 and $1,000 because both
distances represent the same 900 percent increases.
Looking at Figure 1.1, we see that the small-company investment did the best overall.
Every dollar invested grew to a remarkable $24,113.43 over the 90 years. The larger com-
mon stock portfolio did less well; a dollar invested in it grew to $4,954.81.

A $1 Investment in Different Types of Portfolios: 1926–2015
FIGURE 1.1 (Year-end 1925 = $1)
100,000
$24,113.43
10,000 Small-company stocks

$4,954.81
1,000
Value of a $1 investment
Large-company
stocks
$120.90
100
Treasury
Long-term bills
government bonds $22.42
$13.21
10
Inflation
0.10
1926 1936 1946 1956 1966 1976 1986 1996 2006 2016
Year-end
Source: Global Financial Data (www.globalfinancialdata.com) and Professor Kenneth R. French, Dartmouth College.
At the other end, the T-bill portfolio grew to only $22.42. This is even less impressive
when we consider the inflation over this period. As illustrated, the increase in the price level
was such that $13.21 is needed just to replace the original $1.
Given the historical record, why would anybody buy anything other than small-company
stocks? If you look closely at Figure 1.1, you will probably see the answer—risk. The T-bill
portfolio and the long-term government bond portfolio grew more slowly than did the stock
portfolios, but they also grew much more steadily. The small stocks ended up on top, but,
as you can see, they grew quite erratically at times. For example, the small stocks were the
worst performers for about the first 10 years and had a smaller return than long-term govern-
ment bonds for almost 15 years.
A LONGE R R AN G E LOOK
The data available on the stock returns before 1925 are not comprehensive, but it is
nonetheless possible to trace reasonably accurate returns in U.S. financial markets as
far back as 1801. Figure 1.2 shows the values, at the end of 2015, of $1 invested since
1801 in stocks, long-term bonds, short-term bills, and gold. The CPI is also included
for reference.
Financial Market History
FIGURE 1.2
Total return indexes (1801–2015)
$100,000,000
$21.9 mil
$10,000,000
Stocks
$1,000,000
$100,000
Value of a $1 Investment
$39,134
Bonds
$10,000
$5,380
Bills
$1,000
$100
Gold $54.71
$19.72
$10
CPI
$1
$0
1816 1836 1856 1876 1896 1916 1936 1956 1976 1996 2016
Year
Sources: Jeremy J. Siegel, Stocks for the Long Run, 3rd ed. (New York: McGraw-Hill, 2003); update through 2009 provided by Jeremy J. Siegel; update through 2015
from Global Financial Data (www.globalfinancialdata.com); and Professor Kenneth R. French, Dartmouth College.
Inspecting Figure 1.2, we see that $1 invested in stocks grew to an astounding $21.9 million
over this 215-year period. During this time, the returns from investing in stocks dwarf those
earned on other investments. Notice also in Figure 1.2 that, after 170 years, gold has man-
aged to outpace inflation beginning in the 1970s.
What we see thus far is that there has been a powerful financial incentive for long-term
investing. The real moral of the story is this: Get an early start!
A CLOSE R LOOK
To illustrate the variability of the different investments and inflation, Figures 1.3 through
1.6 plot the year-to-year percentage returns in the form of vertical bars drawn from the hori-
zontal axis. The height of a bar tells us the return for the particular year. For example, look-
ing at the long-term government bonds (Figure 1.5), we see that the largest historical return
(47.14 percent) occurred in 1982. This year was a good year for bonds. In comparing these
charts, notice the differences in the vertical axis scales. With these differences in mind, you
can see how predictably the Treasury bills (bottom of Figure 1.5) behaved compared to the
small-company stocks (Figure 1.4).
The returns shown in these bar graphs are sometimes very large. Looking at the graphs,
we see, for example, that the largest single-year return was a remarkable 153 percent for

Year-to-Year Total Returns on Large-Company Stocks: 1926–2015
FIGURE 1.3
Large-company stocks
60
40
Total annual returns (in percent)
20
-20
-40
-60
1926 1936 1946 1956 1966 1976 1986 1996 2006 2016
Year-end
Source: Professor Kenneth R. French, Dartmouth College.
Year-to-Year Total Returns on Small-Company Stocks: 1926–2015

FIGURE 1.4
Small-company stocks
200
150
100
50
-50
-100
1926 1936 1946 1956 1966 1976 1986 1996 2006 2016
Year-end
Year-to-Year Total Returns on Bonds and Bills: 1926–2015
FIGURE 1.5
Long-term U.S. government bonds
60
50
40
30
20
10
-10
-20
-30
1926 1936 1946 1956 1966 1976 1986 1996 2006 2016
Year-end
U.S. Treasury bills

16
14
12
10
-2
1926 1936 1946 1956 1966 1976 1986 1996 2006 2016
Year-end
Source: Global Financial Data (www.globalfinancialdata.com).
the small-company stocks in 1933. In the same year, the large-company stocks returned
“only” 53 percent. In contrast, the largest Treasury bill return was 14.6 percent, in 1981.
The Treasury bill return was near zero through 2015. For future reference, the actual year-
to-year returns for the S&P 500, long-term U.S. government bonds, U.S. Treasury bills, and
the CPI are shown in Table 1.1.

Year-to-Year Inflation: 1926–2015
FIGURE 1.6
Inflation
Cumulative index and rates of change
20
15
Annual inflation (in percent)
10
-5
-10
-15
1926 1936 1946 1956 1966 1976 1986 1996 2006 2016
Year-end
Source: Global Financial Data (www.globalfinancialdata.com).
2008: THE B E A R G ROWL E D A N D I N V E STOR S HOWLE D

As we mentioned in our chapter introduction, 2008 entered the record books as one of the
worst years for stock market investors in U.S. history. Over the extended period beginning in
October 2007 (when the decline began) through March 2009, the S&P 500 Index declined
from 1,576 to 677, a drop of about 57 percent. Stock investors fared much better during the
rest of 2009. The S&P 500 stood at 1,115 at year’s end—a rebound of 65 percent from the
March low.
Figure 1.7 shows the month-by-month performance of the S&P 500 during 2008.
As indicated, returns were negative in 8 of the 12 months. Most of the damage occurred
in the fall, with investors losing almost 17 percent in October alone. Small stocks fared
no better. They fell 37 percent for the year (with a 21 percent drop in October), their worst
performance since losing 58 percent in 1937.
As Figure 1.7 suggests, stock prices were highly volatile during 2008. Oddly, the
S&P had 126 up days and 126 down days (remember the markets are closed week-
ends and holidays). Of course, the down days were much worse on average. To see how
extraordinary volatility was in 2008, consider that there were 18 days during which
the value of the S&P changed by more than 5 percent. There were only 17 such moves
between 1956 and 2007!
The drop in stock prices in 2008 was a global phenomenon, and many of the world’s
major markets were off by much more than the S&P. China, India, and Russia, for example,
all experienced declines of more than 50 percent. Tiny Iceland saw share prices drop by
more than 90 percent for the year. Trading on the Icelandic exchange was temporarily sus-
pended on October 9. In what has to be a modern record for a single day, stocks fell by
76 percent when trading resumed on October 14.
Did U.S. investors encounter any bright spots? The answer is yes: As stocks plummeted,
bonds soared, particularly U.S. Treasury bonds. In fact, long-term Treasuries gained over
40 percent in 2008, while shorter term Treasury bonds were up 13 percent. Long-term cor-
porate bonds did not fare as well but still managed to finish in positive territory, up 9 percent.
TABLE 1.1 Year-to-Year Total Returns: 1926–2015
LONG-TERM LONG-TERM U.S.
LARGE-COMPANY U.S. GOVERNMENT U.S. TREASURY CONSUMER LARGE-COMPANY GOVERNMENT U.S. TREASURY CONSUMER
YEAR STOCKS BONDS BILLS PRICE INDEX YEAR STOCKS BONDS BILLS PRICE INDEX
1926 11.14% 8.26% 3.30% 1971 14.30% 12.67% 4.36% 3.27%

−1.12%
1927 37.13% 11.15% 3.15% −2.26% 1972 18.99% 9.15% 4.23% 3.41%
1928 43.31% −1.90% 4.05% −1.16% 1973 −14.69% −12.66% 7.29% 8.71%
1929 −8.91% 5.41% 4.47% 0.58% 1974 −26.47% −3.05% 7.99% 12.34%
1930 −25.26% 6.08% 2.27% −6.40% 1975 37.23% 4.86% 5.87% 6.94%
1931 −43.86% −9.26% 1.15% −9.32% 1976 23.93% 17.86% 5.07% 4.86%
1932 −8.85% 15.37% 0.88% −10.27% 1977 −7.16% 2.57% 5.45% 6.70%
1933 52.88% −0.04% 0.52% 0.76% 1978 6.57% −1.61% 7.64% 9.02%
1934 −2.34% 14.16% 0.27% 1.52% 1979 18.61% −2.08% 10.56% 13.29%
1935 47.22% 6.24% 0.17% 2.99% 1980 32.50% −4.96% 12.10% 12.52%
1936 32.80% 9.05% 0.17% 1.45% 1981 −4.92% 0.69% 14.60% 8.92%
1937 −35.26% −0.69% 0.27% 2.86% 1982 21.55% 47.14% 10.94% 3.83%
1938 33.20% 6.96% 0.06% −2.78% 1983 22.56% −1.14% 8.99% 3.79%
1939 −0.91% 6.34% 0.04% 0.00% 1984 6.27% 16.29% 9.90% 3.95%
1940 −10.08% 11.88% 0.04% 0.71% 1985 31.73% 36.59% 7.71% 3.80%
1941 −11.77% −10.51% 0.14% 9.93% 1986 18.67% 30.93% 6.09% 1.10%
1942 21.07% 2.70% 0.34% 9.03% 1987 5.25% −7.14% 5.88% 4.43%
1943 25.76% 2.50% 0.38% 2.96% 1988 16.61% 8.75% 6.94% 4.42%
1944 19.69% 2.94% 0.38% 2.30% 1989 31.69% 21.30% 8.44% 4.65%
1945 36.46% 5.69% 0.38% 2.25% 1990 −3.10% 5.66% 7.69% 6.11%
1946 −8.18% 4.41% 0.38% 18.13% 1991 30.47% 19.47% 5.43% 3.06%
1947 5.24% −1.77% 0.62% 8.84% 1992 7.62% 8.08% 3.48% 2.90%
1948 5.10% 2.03% 1.06% 2.99% 1993 10.08% 21.53% 3.03% 2.75%
1949 18.06% 7.91% 1.12% −2.07% 1994 1.32% −10.64% 4.39% 2.67%
1950 30.58% −2.12% 1.22% 5.93% 1995 37.58% 35.66% 5.61% 2.54%
1951 24.55% −4.64% 1.56% 6.00% 1996 22.96% −2.54% 5.14% 3.32%
1952 18.50% 1.69% 1.75% 0.75% 1997 33.36% 17.70% 5.19% 1.70%
Chapter 1
1953 −1.10% −1.54% 1.87% 0.75% 1998 28.58% 19.22% 4.86% 1.61%
1954 52.40% 8.77% 0.93% −0.74% 1999 21.04% −12.76% 4.80% 2.68%
1955 31.43% −1.63% 1.80% 0.37% 2000 −9.10% 22.16% 5.98% 3.39%
1956 6.63% −4.04% 2.66% 2.99% 2001 −11.89% 5.32% 3.33% 1.55%
1957 −10.85% 5.44% 3.28% 2.90% 2002 −22.10% 14.23% 1.61% 2.38%
1958 43.34% −7.80% 1.71% 1.76% 2003 28.68% 1.51% 1.03% 1.88%
1959 11.90% −1.81% 3.48% 1.73% 2004 10.88% 10.53% 1.43% 3.26%
1960 0.48% 8.04% 2.81% 1.36% 2005 4.91% 10.56% 3.30% 3.42%
1961 26.81% 2.94% 2.40% 0.67% 2006 15.80% 0.11% 4.97% 2.54%
1962 −8.78% 4.67% 2.82% 1.33% 2007 5.49% 11.07% 4.52% 4.08%
1963 22.69% 1.14% 3.23% 1.64% 2008 −37.00% 41.78% 1.24% 0.09%
1964 16.36% 4.45% 3.62% 0.97% 2009 26.46% −25.61% 0.15% 2.72%
1965 12.36% 1.15% 4.06% 1.92% 2010 15.06% 7.73% 0.14% 1.50%
1966 −10.10% −2.01% 4.94% 3.46% 2011 2.11% 35.75% 0.06% 2.96%
1967 23.94% −7.02% 4.39% 3.04% 2012 16.00% 1.80% 0.08% 1.74%
1968 11.00% 5.36% 5.49% 4.72% 2013 32.39% −14.69% 0.05% 1.50%
A Brief History of Risk and Return13

1969 −8.47% −0.67% 6.90% 6.20% 2014 13.69% 29.76% 0.03% 0.76%
1970 3.94% 12.24% 6.50% 5.57% 2015 1.38% −2.61% 0.06% 0.73%
Source: Author calculations based on data obtained from Global Financial Data (www.globalfinancialdata.com) and Professor Kenneth R. French, Dartmouth College.
S&P 500 Monthly Returns: 2008
FIGURE 1.7
10%
4.87%
5%
1.30% 1.45% 1.06%
0%
-0.43% -0.84%
-3.25%
-5%
-6.00%
-7.18%
-10% -8.43% -8.91%
-15%
-16.80%
-20%
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Source: Author calculations.
These returns were especially impressive considering that the rate of inflation, as measured
by the CPI, was essentially zero.
What lessons should investors take away from this very recent bit of capital market
history? First, and most obviously, stocks have significant risk! But note a second, equally
important lesson: Depending on the mix, a diversified portfolio of stocks and bonds
probably would have suffered in 2008, but the losses would have been much smaller than
those experienced by an all-stock portfolio. In other words, diversification matters, a point
we will examine in detail in our next chapter.
CHECK 1.2a With 20-20 hindsight, which investment category performed best for the
period 1926–35?
THIS
1.2b Why doesn’t everyone just buy small-company stocks as investments?
1.2c What was the smallest return observed over the 90 years for each category
of investments? Approximately when did it occur?
1.2d About how many times did large-company stocks (common stocks) return more
than 30 percent? How many times did they return less than −20 percent?
1.2e What was the longest “winning streak” (years without a negative return) for
large-company stocks? For long-term government bonds?
1.2f How often did the T-bill portfolio have a negative return?
1.3 Average Returns: The First Lesson

As you’ve probably begun to notice, the history of financial market returns in an undigested
form is complicated. What we need are simple measures to accurately summarize and
describe all these numbers. Accordingly, we discuss how to go about condensing detailed
numerical data. We start by calculating average returns.
TABLE 1.2 Average Annual Returns: 1926 –2015
Investment Average Return
Large-company stocks 11.9%

Small-company stocks 17.5
Long-term corporate bonds 6.5
Long-term government bonds 6.2
U.S. Treasury bills 3.6
Inflation 3.0
Source: Author calculations using data from Global Financial Data (www.globalfinancialdata.com) and Professor Kenneth
R. French, Dartmouth College.
CALC U L ATI N G AV E R AG E R E TU R N S
The obvious way to calculate average returns on the different investments in Figures 1.3
to 1.5 is to simply add up the yearly returns and divide by 90. The result is the historical
average of the individual values. For example, if you add the returns for large-company
common stocks for the 90 years, you will get about 1,067 percent. The average annual return
is thus 1,067/90 = 11.9. You can interpret this 11.9 percent just like any other average.
If you picked a year at random from the 90-year history and you had to guess the return in
that year, the best guess is 11.9 percent.
AVER AGE R E TUR N S: THE HI STOR I CA L R E C OR D

Table 1.2 shows the average returns for the investments we have discussed. Because these
averages do not reflect the impact of inflation, we include an average inflation rate. Notice
that over this 90-year period, the average inflation rate was 3.0 percent per year while the
average return on U.S. Treasury bills was 3.6 percent per year. Thus, the average return on
Treasury bills exceeded the average rate of inflation by only 0.6 percent per year. At the
other extreme, the return on small-company common stocks exceeded the rate of inflation by
about 17.5% − 3.0% = 14.5%. The real return of the large-company common stocks averaged
11.9% − 3.0% = 8.9% per year.
RIS K P R E MI U MS
Now that we have computed some average returns, it seems logical to see how they compare with
each other. Based on our discussion above, one such comparison involves government-issued
securities. These are free of much of the variability we see in, for example, the stock market.
The government borrows money by issuing debt, that is, bonds. These bonds come in dif-
ferent forms. The ones we focus on are Treasury bills. Treasury bills have the shortest time
to maturity of the different types of government debt. Because the government can always
raise taxes or print money to pay its expenses, Treasury bills are virtually free of any default
risk-free rate risk. Thus, we will call the rate of return on such debt the risk-free rate, and we will use it
The rate of return on a riskless as a kind of investing benchmark.
investment. A particularly interesting comparison involves the virtually risk-free return on T-bills and
the risky return on common stocks. The difference between these two returns can be inter-
preted as a measure of the excess return on the average risky asset (assuming that the stock
of a large U.S. corporation has about average risk compared to all risky assets).
We call this the “excess” return because it is the additional return we earn by moving from
a virtually risk-free investment to a risky one. Because this excess return can be interpreted
risk premium as a reward for bearing risk, we will call it a risk premium.
The extra return on a risky
asset over the risk-free rate; THE U.S. EQUITY RISK PREMIUM: HISTORICAL AND INTERNATIONAL
the reward for bearing risk. PERSPECTIVES So far, in this chapter we have studied returns in U.S. stock and bond
markets in the period 1926–2015. As we have discussed, the historical U.S. stock market
risk premium has been substantial. Of course, whenever we use the past to predict the future,
there is a danger that the past period isn’t representative of what the future will hold. Perhaps

TABLE 1.3 World Stock Market Capitalization 2015 and 2014
2015 2014
Amount Amount
Region/Country (in trillions) Percent (in trillions) Percent
United States $25.1 37.4% $26.3 38.7%

Canada 1.6 2.4 2.1 3.1
Americas, excluding U.S. and Canada 1.3 1.9 1.9 2.8
Japan 4.9 7.3 4.4 6.5
Asia-Pacific, excluding Japan 18.3 27.3 16.7 24.6
United Kingdom 3.9 5.8 4.0 5.9
Germany 1.7 2.5 1.7 2.5
Europe, Africa, Middle East,
excluding United Kingdom and Germany 10.3 15.4 10.9 16.0
Total $67.1 $68.0
Source: World Federation of Exchanges Database, http://www.world-exchanges.org/home/index.php/statistics/

monthly-reports.
U.S. investors got lucky over this period and earned particularly large returns. Data from
earlier years are available, although not of the same quality. With that caveat in mind,
researchers have tracked returns back to 1802. The U.S. equity risk premium in the pre-1926
era was smaller than it was in the post-1926 era. Using the U.S. return data from 1802 to
2006, the historical equity risk premium was 5.4 percent.
We have not looked at stock returns in other major countries. Actually, more than half of
the value of tradable stock is not in the United States. From Table 1.3, we can see that while
the total world stock market capitalization was $67.1 trillion in 2015, only about 37.4 percent
was in the United States.
Thanks to Professors Elroy Dimson, Paul Marsh, and Michael Staunton, data from earlier
periods and other countries are now available to help us take a closer look at equity risk
premiums. The U.S. historical equity risk premium is the eighth highest at 7.4 percent (which
differs from our estimate below because of the different time periods examined). The overall
world average risk premium is 7.1 percent. It seems clear that U.S. investors did well, but
not exceptionally so relative to many other countries. The top performing countries were
the United States, Australia, and France; the worst performers were Denmark and Norway.
Germany, Japan, and Italy might make an interesting case study because they have the high-
est stock returns over this period (despite World Wars I and II), but also the highest risk.
What is a good estimate of the U.S. equity risk premium going forward? Unfortunately,
nobody can know for sure what investors expect in the future. If history is a guide, the expected
U.S. equity risk premium could be 7.4 percent based upon estimates from 1900–2005.
We should also be mindful that the average world equity risk premium was 7.1 percent
over this same period. On the other hand, the relatively more recent period (1926–2015)
suggests higher estimates of the U.S. equity risk premium, and the earlier period (1802–
1925) suggests lower estimates. Taking a slightly different approach, Professor Ivo Welch
asked the opinions of 226 financial economists regarding the future U.S. equity risk
premium. The median response was 7 percent.
Estimates of the future U.S. equity risk premium that are somewhat higher or lower could
be reasonable, especially if we have good reason to believe the past is not representative of
the future. The bottom line is that any estimate of the future equity risk premium will involve
assumptions about the future risk environment as well as the amount of risk aversion of
future investors.
T H E FIRST L E SSON
From the data in Table 1.2, we can calculate risk premiums for the five different categories
of investments. The results are shown in Table 1.4. Notice that the risk premium on T-bills
is shown as zero in the table because they are our riskless benchmark. Looking at Table 1.4,
TABLE 1.4 Average Annual Returns and Risk Premiums: 1926 –2015
Investment Average Return Risk Premium
Large-company stocks 11.9% 8.3%

Small-company stocks 17.5 13.9
Long-term corporate bonds 6.5 2.9
Long-term government bonds 6.2 2.6
U.S. Treasury bills 3.6 0.0
Source: Author calculations using data from Global Financial Data (www.globalfinancialdata.com) and Professor Kenneth
R. French, Dartmouth College.
we see that the average risk premium earned by the large-company common stock portfo-
lio is 11.9% − 3.6% = 8.3%. This difference is a significant reward. The fact that it exists
historically is an important observation, and it is the basis for our first lesson: Risky
assets, on average, earn a risk premium. Put another way, there is a reward, on average,
for bearing risk.
Why is this so? Why, for example, is the risk premium for small stocks so much larger
than the risk premium for large stocks? More generally, what determines the relative sizes
of the risk premiums for the different assets? These questions are at the heart of the modern
theory of investments. We will discuss the issues involved many times in the chapters ahead.
For now, part of the answer can be found by looking at the historical variability of the returns
of these different investments. So, to get started, we now turn our attention to measuring
variability in returns.
CHECK 1.3a What do we mean by excess return and risk premium?
THIS 1.3b What is the historical risk premium on small-company stocks? On U.S.
Treasury bonds?
1.3c What is the first lesson from financial market history?
1.4 Return Variability: The Second Lesson

We have already seen that the year-to-year returns on common stocks tend to be more
volatile than returns on, say, long-term government bonds. We now discuss measuring this
variability so we can begin examining the subject of risk.
FREQ UE NCY D I STR I B UTI ON S A N D VA R I A B I L I TY

To get started, we can draw a frequency distribution for large-company stock returns like the
one in Figure 1.8. What we have done here is to count the number of times that an annual
return on the large-company stock portfolio falls within each 10 percent range. For example,
in Figure 1.8, the height of 18 for the bar within the interval 10 percent to 20 percent means
that 18 of the 90 annual returns are in that range. Notice also that most of the returns are in
the −10 to 40 percent range.
What we need to do now is to measure the spread in these returns. We know, for example,
that the return on large-company stocks in a typical year was 11.9 percent. We now want
to know by how much the actual return differs from this average in a typical year. In other
variance words, we need a measure of the volatility of returns. The variance and its square root, the
A common measure of volatility. standard deviation, are the most commonly used measures of volatility. We describe how
standard deviation to calculate them next. If you’ve already studied basic statistics, you should notice that we
The square root of the are simply calculating an ordinary sample variance and standard deviation, just as you may
variance. have done many times before.

Frequency Distribution of Returns on Large-Company
FIGURE 1.8 Common Stocks: 1926–2015
2014
2012
2010
2015 2006
2011 2004 2009 2013
2000 2007 1988 2003 1997
1990 2005 1986 1999 1995
1981 1994 1979 1998 1991
1977 1993 1972 1996 1989
1969 1992 1971 1983 1985
1962 1987 1968 1982 1980
1953 1984 1965 1976 1975
1946 1978 1964 1967 1955
2001 1940 1970 1959 1963 1950
1973 1939 1960 1952 1961 1945
2002 1966 1934 1956 1949 1951 1938 1958
2008 1974 1957 1932 1948 1944 1943 1936 1935 1954
1931 1937 1930 1941 1929 1947 1926 1942 1927 1928 1933
-80 -70 -60 -50 -40 -30 -20 -10 0 10 20 30 40 50 60 70 80 90
Percent
T H E H ISTOR ICA L VA R I A N C E A N D STA N DA R D D E V I AT I O N

The variance essentially measures the average squared difference between the actual returns
For an easy-to-read
review of basic and the average return. The bigger this number is, the more the actual returns tend to
statistics, see differ from the average return. Also, the larger the variance or standard deviation is, the
www.robertniles.com/stats/ more spread out the returns will be.
The way we calculate the variance and standard deviation depends on the specific
situation. In this chapter, we are looking at historical returns. Therefore, the procedure
we describe here is the correct one for calculating the historical variance and standard
deviation. If we were examining projected future returns, then the procedure would be
different. We describe this procedure in a later chapter.
To illustrate how we calculate the historical variance, suppose a particular investment
had returns of 10 percent, 12 percent, 3 percent, and −9 percent over the last four years.
The average return is (0.10 + 0.12 + 0.03 − 0.09)/4 = 0.04, or 4 percent.
Notice that the return is never actually equal to 0.04, or 4 percent. Instead, the first return
deviates from the average by 0.10 − 0.04 = 0.06, the second return deviates from the average
by 0.12 − 0.04 = 0.08, and so on. To compute the variance, we square each of these devia-
tions, add them up, and divide the result by the number of returns less 1, or 3 in this case.
These calculations are summarized in the following table:
(1) (2) (3) (4)

Year Actual Return Average Return Deviation (1) – (2) Squared Deviation
1 0.10 0.04 0.06 0.0036

2 0.12 0.04 0.08 0.0064
3 0.03 0.04 −0.01 0.0001
4 −0.09 0.04 −0.13 0.0169
Totals 0.16 0.00 0.0270
In the first column, we write down the four actual returns. In the third column, we calcu-
late the difference between the actual returns and the average by subtracting out 4 percent.
Finally, in the fourth column, we square the numbers in column 3 to get the squared devia-
tions from the average.
The variance can now be calculated by dividing 0.0270, the sum of the squared
deviations, by the number of returns less 1. Let Var(R) or σ2 (read this as “sigma squared”)
stand for the variance of the return:
Var(R) = σ2 = 0.027/ (4 − 1) = 0.009
The standard deviation is the square root of the variance. So, if SD(R) or σ stands for
the standard deviation of the return:
______
SD(R) = σ = √ 0.009   
= 0.09487
The square root of the variance is used because the variance is measured in “squared”
percentages and thus is hard to interpret. The standard deviation is an ordinary percentage,
so the answer here could be written as 9.487 percent.
In the table above, notice that the sum of the deviations is equal to zero. This will always
be the case, and it provides a good way to check your work. In general, if we have N historical
returns, where N is some number, we can write the historical variance as:
1     
Var(R) =  _____ ¯ )2 + . . . + (R −   R 
[(R1 −   R  ¯ )2]
N − 1 N
This formula tells us to do just what we did above: Take each of the N individual returns
¯ ; square the results and add up all these
(R1, R2, . . . , RN) and subtract the average return,  R 
squares; and, finally, divide this total by the number of returns minus 1 (i.e., N − 1).2
The standard deviation is the square root of Var(R). In many areas, including finance,
standard deviations are used to measure variability.
EXAMPLE 1.4 Calculating the Variance and Standard Deviation

From Table 1.1, we see that the large-company stocks and long-term government bonds
had these returns for the past four years:
Large-Company Long-Term
Year Stocks Government Bonds
2012 0.1600 0.0180

2013 0.3239 −0.1469
2014 0.1369 0.2976
2015 0.0138 −0.0261
What are the average returns? The variances? The standard deviations?
To calculate the average returns, we add up the returns and divide by four.
The results are:
¯  = 0.6346 / 4 = 0.1587
Large-company stocks, average return =   R 
¯  = 0.1425 / 4 = 0.0356
Long-term government bonds, average return =   R 
(continued)
2
The reason for dividing by N − 1 rather than simply N is based on statistical sampling theory, which is beyond
the scope of this book. Just remember that to calculate a variance about a sample average, you need to divide the
sum of squared deviations from the average by N − 1.

To calculate the variance for large-company stocks, we can summarize the relevant
calculations (with rounding) as follows:
(1) (2) (3) (4)

Year Actual Return Average Return Deviation (1) – (2) Squared Deviation
2012 0.1600 0.1587 0.0013 0.000002

2013 0.3239 0.1587 0.1652 0.027291
2014 0.1369 0.1587 −0.0218 0.000475
2015 0.0138 0.1587 −0.1449 0.020996
Totals 0.6346 0.0000 0.0488
Because there are four years of returns, we calculate the variance by dividing 0.0488
by (4 − 1) = 3:
Large-Company Stocks Long-Term Government Bonds
Variance (σ2) 0.0488/3 = 0.01625 0.1061/3 = 0.03536

________ ________
Standard deviation (σ) = 0.12749
√ 0.01625   = 0.18802
 0.03536  
√
For practice, verify that you get the same answers that we do for long-term govern-
ment bonds. Notice that the standard deviation for long-term government bonds,
18.80 percent, is actually higher than the standard deviation for large-company stocks,
12.75 percent, over this short period. Why is this relationship unusual?
T H E H ISTOR ICA L R E C OR D
Figure 1.9 summarizes much of our discussion of capital market history so far. It dis-
plays average returns, standard deviations, and frequency distributions of annual returns
on a common scale. In Figure 1.9, notice, for example, that the standard deviation for
the small-stock portfolio (36.3 percent per year) is more than 10 times larger than the
T-bill portfolio’s standard deviation (3.2 percent per year). We will return to discuss these
facts momentarily.
NORMAL DISTR I B U TI ON
normal distribution For many different random events in nature, a particular frequency distribution, the normal
A symmetric, bell-shaped fre- distribution (or bell curve) is useful for describing the probability of ending up in a given
quency distribution that is com- range. For example, the idea behind “grading on a curve” is based on the fact that exam
pletely defined by its average scores often resemble a bell curve.
and standard deviation. Figure 1.10 illustrates a normal distribution and its distinctive bell shape. As you can see,
this distribution has a much cleaner appearance than the actual return distributions illustrated
in Figure 1.8. Even so, like the normal distribution, the actual distributions do appear to be
at least roughly mound shaped and symmetric. When this shape is observed, the normal
distribution is often a very good approximation.
Also, keep in mind that the distributions in Figure 1.9 are based on only 90 yearly obser-
vations, while Figure 1.10 is, in principle, based on an infinite number. So, if we had been
able to observe returns for, say, 1,000 years, we might have filled in a lot of the irregularities
and ended up with a much smoother picture. For our purposes, it is enough to observe that
the returns are at least roughly normally distributed.
The usefulness of the normal distribution stems from the fact that it is completely described
by the average and the standard deviation. If you have these two numbers, then there is
nothing else you need to know. For example, with a normal distribution, the probability
Historical Returns, Standard Deviations, and
FIGURE 1.9 Frequency Distributions: 1926–2015
Average Standard
Series Return Deviation Frequency Distribution
Large-company
stocks 11.9% 20.0%
Small-company
stocks* 17.5% 36.3%
Long-term
corporate bonds 6.5% 7.0%
Long-term U.S.
government bonds 6.2% 12.5%
Intermediate-term U.S.
government bonds 5.5% 8.1%
U.S. Treasury bills 3.6% 3.2%
Inflation 3.0% 4.1%
-90% 0% 90%
*The 1933 small-company stocks total return was 153.2 percent.
Source: Author calculations using data from Global Financial Data (www.globalfinancialdata.com) and Professor Kenneth R. French, Dartmouth College.
The Normal Distribution: Illustrated Returns Based on the Historical

Return and Standard Deviation for a Portfolio of Large-Company
FIGURE 1.10 Common Stocks
Probability
68%
95%
>99% Return on
large-company
-3σ -2σ -1σ 0 +1σ +2σ +3σ common stocks
-48.1% -28.1% -8.1% 11.9% 31.9% 51.9% 71.9%

that we end up within one standard deviation of the average is 68 percent, or about 2/3.
The probability that we end up within two standard deviations is about 95 percent. Finally,
the probability of being more than three standard deviations away from the average is
less than 1 percent. These ranges and the probabilities are illustrated in Figure 1.10.
To see why this range is useful, recall from Figure 1.9 that the standard deviation
of returns on the large-company common stocks is 20.0 percent. The average return is
11.9 percent. So, assuming that the frequency distribution is at least approximately normal,
the probability that the return in a given year is in the range of −8.1 percent to 31.9 percent
(11.9 percent plus or minus one standard deviation, 20.0 percent) is about 2/3. This range is
illustrated in Figure 1.10. In other words, there is about one chance in three that the return
will be outside this range. Therefore, if you buy stocks in large companies, you should expect
to be outside this range in one year out of every three. This reinforces our earlier observations
about stock market volatility. However, there is only a 5 percent chance (approximately) that
we would end up outside the range of −28.1 percent to 51.9 percent (11.9 percent plus or
minus 2 × 20.0%). These points are also shown in Figure 1.10.
T H E S ECOND L E SSON
Our observations concerning the year-to-year variability in returns are the basis for our
second lesson from capital market history. On average, bearing risk is handsomely rewarded,
but, in a given year, there is a significant chance of a dramatic change in value. Thus, our
second lesson is this: The greater the potential reward is, the greater the risk is.
Thus far in this chapter, we have emphasized the year-to-year variability in returns.
We should note that even day-to-day movements can exhibit considerable volatility. For
example, on September 29, 2008, the Dow Jones Industrial Average (DJIA) plummeted
777.68 points, or 6.98 percent. By historical standards, it was one of the worst days
ever for the 30 stocks that comprise the DJIA (as well as for a majority of stocks in the
market). Still, while the drop was the largest one-day decrease in the DJIA ever in terms
of points, it was not in the top 10 largest one-day percentage decreases in history, as
shown in Table 1.5.
This discussion highlights the importance of looking at returns in terms of percentages
rather than dollar amounts or index points. For example, before 2008, the biggest one-day
loss in terms of points was on September 17, 2001, when the DJIA declined by about 685
points. The second worst was the 618-point drop of April 14, 2000. By contrast, the 5.79-
point drop in the DJIA on August 12, 1932, marked the eighth worst percentage drop in
the history of the index (for practice, verify that the previous day’s level of the DJIA was
68.90). A 5.79-point loss in the DJIA in today’s market, however, would hardly be noticed.
This is precisely why we relied on percentage returns when we examined market history
in this chapter.3
Now that you know how to calculate and, more important, interpret average returns and
standard deviations, the nearby Spreadsheet Analysis box shows how to do the calculations
using Excel, which can really speed up things when we have a lot of data.
EXAMPLE 1.5 Investing in Growth Stocks

The term growth stock is frequently a euphemism for small-company stock. Are such
investments suitable for “widows and orphans”? Before answering, you should consider
the historical volatility. For example, from the historical record, what is the approximate
probability that you will actually lose 16 percent or more of your money in a single year
if you buy a portfolio of such companies?
(continued)
3
By the way, as you may have noticed, what’s kind of weird is that 6 of the 12 worst days in the history of the DJIA
occurred in October, including the top 3. We have no clue as to why. Furthermore, looking back at the Mark Twain
quote near the beginning of the chapter, how do you suppose he knew? Sounds like a case for CSI: Wall Street.
Good Times, Bad Times (You Know I’ve Had My Share):
TABLE 1.5 The Best and Worst Days for the DJIA: May 1896 to March 2016
Panel A. The Best Days
Point Percentage
Date Index Level Increase Rank Date Index Level Increase
2008-10-13 9,387.61 936.42 1 1933-03-15 62.10 15.3%

2008-10-28 9,065.12 889.35 2 1931-10-06 99.34 14.9%
2015-08-26 16,285.51 619.07 3 1929-10-30 258.47 12.3%
2008-11-13 8,835.25 552.59 4 1931-06-22 145.82 11.9%
2000-03-16 10,630.61 499.19 5 1932-09-21 75.16 11.4%
03-23-2009 7,775.86 497.48 6 2008-10-13 9,387.61 11.1%
2008-11-21 8,046.42 494.13 7 2008-10-28 9,065.12 10.9%
2011-11-30 12,045.68 490.05 8 1987-10-21 2,027.85 10.1%
2002-07-24 8,191.29 488.95 9 1932-08-03 58.22 9.5%
2008-09-30 10,850.66 485.21 10 1939-09-05 148.12 9.5%
Panel B. The Worst Days
Point Percentage
Date Index Level Decrease Rank Date Index Level Decrease
2008-09-29 10,365.45 −777.68 1 1987-10-19 1,738.74 −22.6%

2008-10-15 8,577.91 −733.08 2 1914-12-14 56.76 −20.5%
2001-09-17 8,920.70 −684.81 3 1929-10-28 260.64 −13.5%
2008-12-01 8,149.09 −679.95 4 1899-12-18 58.27 −12.0%
2008-10-09 8,579.19 −678.91 5 1929-10-29 230.07 −11.7%
2011-08-08 10,809.85 −634.76 6 1931-10-05 86.48 −10.7%
2000-04-14 10,305.78 −617.77 7 1929-11-06 232.13 −9.9%
1997-10-27 7,161.14 −544.26 8 1932-08-12 63.11 −8.4%
2015-08-24 15,871.35 −588.40 9 1907-03-14 76.23 −8.3%
2015-08-21 16,459.75 −530.94 10 1932-01-04 71.59 −8.1%
Source: Author calculations and FRED, the database maintained by the Federal Reserve Bank of St. Louis.
Looking back at Figure 1.9, we see that the average return on small stocks is 17.5
percent and the standard deviation is 36.3 percent. Assuming that the returns are
approximately normal, there is about a 1/3 probability that you will experience a return
outside the range of −18.8 percent to 53.8 percent (17.5% ± 36.3%).
Because the normal distribution is symmetric, the odds of being above or below
this range are equal. There is thus a 1/6 chance (half of 1/3) that you will lose more than
18.8 percent. So, you should expect this to happen once in every six years, on average.
Such investments can thus be very volatile, and they are not well suited for those who
cannot afford the risk.
CHECK 1.4a In words, how do we calculate a variance? A standard deviation?
THIS 1.4b What is the second lesson from financial market history?

SPREADSHEET ANALYSIS
Using a Spreadsheet to Calculate Average Returns and Volatilities
Here is an Excel spreadsheet summarizing the formulas and analysis needed to calculate
average returns and standard deviations using the 1990s as an example:
A B C D E F G H
1
2 Using a spreadsheet to calculate average returns and standard deviations
3
4 Looking back in the chapter, the data suggest that the 1990s were one
5 of the best decades for stock market investors. We will find out just how good by
6 calculating the average returns and standard deviations for this period. Here are the
7 year-by-year returns on the large-company stocks:
8
9 Year Return (%) Year Return (%)
10 1990 3.10 1995 37.58
11 1991 30.46 1996 22.96
12 1992 7.62 1997 33.36
13 1993 10.08 1998 28.58
14 1994 1.32 1999 21.04
15
16 Average return (%): 18.99
17 Standard deviation (%): 14.16
18
19 The formulas we used to do the calculations are just =AVERAGE(C10:C14;E10:E14)
20 and =STDEV(C10:C14;E10:E14). Notice that the average return in the 1990s was 18.99
21 percent per year, which is larger than the long-run average of 11.9 percent. At the same
22 time, the standard deviation, 14.16 percent, was smaller than the 20.0 percent long-run value.
1.5 More on Average Returns

Thus far in this chapter, we have looked closely at simple average returns. But there is
another way of computing an average return. The fact that average returns are calculated
two different ways leads to some confusion, so our goal in this section is to explain the two
approaches and also explain the circumstances under which each is appropriate. In addition,
we include a measure of return that accounts for investor decisions to add funds to or remove
funds from an investment.
ARIT HME TIC V E R SU S G E OME TR I C AV E R AG E S

Let’s start with a simple example. Suppose you buy a particular stock for $100. Unfortunately,
the first year you own it, it falls to $50. The second year you own the stock, its price increases
to $100, leaving you where you started (no dividends were paid).
What was your average return on this investment? Common sense seems to say that
your average return must be exactly zero since you started with $100 and ended with $100.
But if we calculate the returns year-by-year, we see that you lost 50 percent the first year
(you lost half of your money). The second year, you made 100 percent (you doubled your
money). Your average return over the two years was thus (−50% + 100%)/2 = 25%! So
which is correct, 0 percent or 25 percent?
INVESTMENT UPDATES
I N V E S T M E N T R E T U R N S : C R U E L M AT H ?
If your portfolio experiences a 20 percent loss, what return recognition of this fact, and the reality of 2008, has
is necessary to bring your portfolio back to “even”? Many led to an increase in the popularity of so-called low-
investors might simply say 20 percent, but they would volatility funds.
be very much incorrect. In fact, you would need to earn
25 percent just to overcome the 20 percent loss and break
even. This is the reality (or cruelty) of math, and it is a func- Loss Gain Needed to Break Even
tion of the key principle of finance: compounding.
−5% 5.26%
This issue became particularly relevant in the wake of
the 2008 financial crisis. For example, as Table 1.1 reports, −10% 11.11%
large-cap U.S. stocks lost 37 percent in 2008. In 2009 and −15% 17.65%
2010, the market recovered, earning 26.46 percent and
−20% 25.00%
15.06 percent, respectively. While these two returns add to
41.52 percent, thereby “exceeding” the loss of 2008, inves- −25% 33.33%
tor portfolios where still under water. In fact, for every $1 −30% 42.86%
held at the beginning of 2008, it would only be worth $0.92
−35% 53.85%
at the end of 2010.
This example clearly illustrates that to offset losses, −40% 66.67%
you need an even bigger gain to get back to where you −45% 81.82%
started. And, as the table below illustrates, this effect
−50% 100.00%
is more pronounced for higher levels of loss. A growing
The answer is that both are correct; they just answer different questions. The 0 percent
geometric average return is called the geometric average return. The geometric average return answers the question
The average compound return “What was your average compound return per year over a particular period?”
earned per year over a multi- The 25 percent is called the arithmetic average return. The arithmetic average
year period. return answers the question “What was your return in an average year over a particular
period?”
arithmetic average return Notice that, in previous sections, the average returns we calculated were all arithme-
The return earned in an aver- tic averages, so you already know how to calculate them. What we need to do now is
age year over a multiyear
(1) learn how to calculate geometric averages and (2) learn the circumstances under which
period.
one average is more meaningful than the other.
Finally, the order and size of losses and gains matter to your portfolio. The nearby
Investment Updates box provides an important example.
CALC U L ATI N G G E OME TR I C AV E R AG E R E TUR N S

If we have N years of returns, the geometric average return over these N years is calculated
using this formula:
Geometric average return = [(1 + R1 ) × (1 + R2) × . . . × (1 + RN )]1/N − 11.5
This formula tells us that four steps are required:

1. Take each of the N annual returns R1, R2, . . . , RN and add a 1 to each (after convert-
ing them to decimals!).
2. Multiply all the numbers from step 1 together.
3. Take the result from step 2 and raise it to the power of 1/N.
4. Finally, subtract 1 from the result of step 3. The result is the geometric average
return.
To illustrate how we calculate a geometric average return, suppose a particular investment
had annual returns of 10 percent, 12 percent, 3 percent, and −9 percent over the last four

TABLE 1.6 Geometric versus Arithmetic Average Returns: 1926–2015
Geometric Arithmetic Standard
Series Mean Mean Deviation
Large-company stocks 9.9% 11.9% 20.0%

Small-company stocks 11.9 17.5 36.3
Long-term corporate bonds 6.3 6.5 7.0
Long-term government bonds 5.5 6.2 12.5
Intermediate-term government bonds 5.3 5.5 8.1
U.S. Treasury bills 3.5 3.6 3.2
Inflation 2.9 3.0 4.1
years. The geometric average return over this four-year period is calculated as (1.10 × 1.12 ×
1.03 × 0.91)1/4 − 1 = 3.66%. In contrast, the average arithmetic return is (0.10 + 0.12 + 0.03 −
0.09)/4 = 4.0%.
One thing you may have noticed in our examples thus far is that the geometric average
returns seem to be smaller. It turns out that this will always be true (as long as the returns
are not all identical, in which case the two “averages” would be the same). To illustrate,
Table 1.6 shows the arithmetic averages and standard deviations from Figure 1.9, along with
the geometric average returns.
As shown in Table 1.6, the geometric averages are all smaller, but the magnitude of
the difference varies quite a bit. The reason is that the difference is greater for more vol-
atile investments. In fact, there is a useful approximation. Assuming all the numbers are
expressed in decimals (as opposed to percentages), the geometric average return is approxi-
mately equal to the arithmetic average return minus half the variance. For example, look-
ing at the large-company stocks, the arithmetic average is 0.119 and the standard deviation
is 0.200, implying that the variance is 0.0400. The approximate geometric average is thus
0.119 − 0.0400/2 = 0.0990, which is extremely close to the actual value.
EXAMPLE 1.6 Calculating the Geometric Average Return

Calculate the geometric average return for the large-company stocks for the last four
years in Table 1.1, 2012–2015.
First, convert percentages to decimal returns, add one, and then calculate their
product.
Year Large-Company Stocks Product
2012 16.00 1.1600

2013 32.39 × 1.3239
2014 13.69 × 1.1369
2015 1.38 × 1.0138
1.7701
Notice that the number 1.7701 is what our investment is worth after five years if we
started with a one-dollar investment. The geometric average return is then calculated as
Geometric average return = 1.7701  ⁄ − 1 = 0.1534, or 15.34%

1
4
(continued)
Thus, the geometric average return is about 15.34 percent in this example. In contrast, in
Example 1.4, the average arithmetic return was calculated as 15.87 percent. Here is a tip:
If you are using a financial calculator, you can put $1 in as the present value, $1.7701 as
the future value, and 4 as the number of periods. Then, solve for the unknown rate.
You should get the same answer for the geometric average as we did here.
EXAMPLE 1.7 More Geometric Averages

Take a look back at Figure 1.1. There, we showed the value of a $1 investment after
90 years. Use the value for the small-company stock investment to check the geometric
average in Table 1.6.
In Figure 1.1, the small-company investment grew to $24,113.43 over 90 years.
The geometric average return is thus
Geometric average return = 24,113.43 1/90− 1 = 0.1186, or about 11.9%
This 11.9% is the value shown in Table 1.6.
ARIT HME TI C AV E R AG E R E TU R N OR
GEOME TR I C AV E R AG E R E TUR N ?
When we look at historical returns, the difference between the geometric and arithmetic
average returns isn’t too hard to understand. To put it slightly differently, the geometric
average tells you what you actually earned per year on average, compounded annually.
The arithmetic average tells you what you earned in a typical year. You should use whichever
one answers the question you want answered.
A somewhat trickier question concerns forecasting the future, and there is a lot of confu-
sion about this point among analysts and financial planners. The problem is the following.
If we have estimates of both the arithmetic and geometric average returns, then the arithme-
tic average is probably too high for longer periods and the geometric average is probably too
low for shorter periods.
The good news is that there is a simple way of combining the two averages, which we will
call Blume’s formula.4 Suppose we calculated geometric and arithmetic return averages from
N years of data and we wish to use these averages to form a T-year average return forecast,
R(T), where T is less than N. Here’s how we do it:
R(T) = (_____
  T − 1  × Geometric average) + (_____
    × Arithmetic average)
  N − T  
N − 1 N − 1
For example, suppose that, from 25 years of annual returns data, we calculate an arithme-
tic average return of 12 percent and a geometric average return of 9 percent. From these
averages, we wish to make 1-year, 5-year, and 10-year average return forecasts. These three
average return forecasts are calculated as follows:
R(1) = (_____ ) + (  24  × 12%) = 12%

  1 − 1
  × 9%
 
  25 − 1 
______ 
24
R(5) = (_____
  5 − 1
  × 9%
 
  ) + (  24  × 12%
25 − 5 
______  ) = 11.5%
24
R(10) = (______
  10 − 1 ) + (  24  × 12%) = 10.875%
  × 9%
 
 
25 − 10 
_______  
24
Thus, we see that 1-year, 5-year, and 10-year forecasts are 12 percent, 11.5 percent, and
10.875 percent, respectively.
4
This elegant result is due to Marshall Blume. (“Unbiased Estimates of Long-Run Expected Rates of Return,”
Journal of the American Statistical Association, September 1974, pp. 634–638.)

This concludes our discussion of geometric versus arithmetic averages. One last note:
In the future, when we say “average return,” we mean arithmetic average unless we explicitly
say otherwise.
EXAMPLE 1.8 Forecasting Average Returns

Over the 90-year period 1926–2015, the geometric average return for large-company
stocks was 9.9 percent and the arithmetic average return was 11.9 percent. Calculate
average return forecasts for 1, 5, 10, and 25 years into the future.
In this case, we would use Blume’s formula with values of T = 1, 5, 10, and 25 and N = 90:
R (T ) = (  × 9.9%) + ( × 11.9%)

T − 1 90 − T
_____
  89   _______
  89    
T R (T )
1 11.9%
5 11.8
10 11.7
25 11.4
90 9.9
Notice that short-term forecasts are closer to the arithmetic average return and
long-term forecasts are closer to the geometric average return.
DOLLAR-WE IG HTE D AV E R AG E R E TU R N S
Suppose an investment had returns of 10 percent and −5 percent over the last two years.
You know how to compute the arithmetic average (2.50 percent) and the geometric average
(2.23 percent). You might not know that these average returns are accurate only if the inves-
tor made a single deposit at the start of the two-year period.
Many investors, however, make deposits or withdrawals through time. For example, some
people add money to their investments over time as they save for retirement. Some people
might be forced to withdraw funds to meet unexpected needs. Other investors attempt to
“time the market” by adding funds because they believe their investments will soon increase
in value. These “market timers” also sell part (or all) of their investments before an antici-
pated decline.
Whether investors can be successful at market timing is a topic of much debate, and one
that we address in later chapters. Still, it is important to know how to calculate the return of
an investment when an investor makes deposits and withdrawals. The relevant return mea-
dollar-weighted average sure in this case is called the dollar-weighted average return.
return As an example, assume that you invest $1,000. After earning 10 percent the first
Average compound rate of year, you decide to invest another $4,000 (perhaps hoping the investment repeats its
return earned per year over performance). Unfortunately for you, the return in year 2 was −5 percent. What was
a multiyear period accounting your net return?
for investment inflows and
To begin to answer this question, you need to know the ending value of your investment.
outflows.
At the end of the first year, your account had a value of $1,100, which is the initial invest-
ment plus the 10 percent return. You then deposited another $4,000, bringing the account
value to $5,100 at the beginning of year 2. After losing 5 percent in year 2, your final value
is $4,845.
Before we set out to calculate your exact return, you know that your return is negative.
After all, you deposited $5,000 out of your own pocket, but at the end of two years the
SPREADSHEET ANALYSIS
A B C D E F G H
1
2 Calculating dollar-weighted average returns
3
4 To find a rate of return that equates a series of uneven cash flows, we must identify
5 when the cash flows were made and we must know their size. Then, we can use
6 the built-in IRR function in Excel to calculate the dollar-weighted average return.
7
8 Time Cash Flow
9 0 -$1,000
10 1 -$4,000
11 2 $4,845
12
13 -2.6% =IRR(C9:C11)
14
15 Note, time 0 is the beginning of year 1, while time 1 is the end of year 1.
16
17 Using the IRR function, we calculate a dollar-weighted average return of -2.6%.
18
19
investment is worth only $4,845. So, the arithmetic and geometric averages, which were both
positive, do not account for this case.
To calculate the dollar-weighted average return, we need to find the average rate of return
that equates our cash outflows to our cash inflows. In other words, what is the rate that makes
the net present value of the investment equal zero? Here is a summary of your cash flows for
this investment:
Time: 0 1 2
Cash flow: −$1,000 −$4,000 +$4,845
In this summary, the negative cash flows are the deposits you made. The positive cash flow
is the amount you have in the investment at the end of year 2.
In a corporate finance class, this calculation is known as the internal rate of return,
or IRR. Finding the IRR requires trial and error, unless you use the help of a financial
calculator or spreadsheet. To see how to do this in Excel, you can look at the nearby
Spreadsheet Analysis box. The dollar-weighted rate of return for this investment is
−2.6 percent. This makes sense because you had the greatest amount invested during
the period when the return was the lowest, and you had the least amount invested when
the return was the highest.
You know that the geometric average is always less than or equal to the arithmetic aver-
age. How about the relationship between the geometric average and the dollar-weighted
average return? As you might guess, the relationship depends on when deposits and with-
drawals were made. The geometric average return could be greater than, less than, or equal to
the dollar-weighted average return. In fact, the geometric average is really just a special case
of the dollar-weighted return, where the additional inflows and outflows happen to be zero.

CHECK 1.5a Over a five-year period, an investment in a broad market index yielded annual
returns of 10, 16, −5, −8, and 7 percent. What were the arithmetic and geo-
THIS metric average annual returns for this index?
1.5b Over a 25-year period, an investment in a broad market index yielded an
arithmetic average return of 4 percent and a geometric average return of
3.6 percent. Using Blume’s formula, what would be the 5-year and 10-year
average return forecasts?
1.5c Why is it important to control for the flow of funds into and out of an invest-
ment when calculating returns?
1.6 Risk and Return

In previous sections, we explored financial market history to see what we could learn about
risk and return. In this section, we summarize our findings and then conclude our discussion
by looking ahead at the subjects we will be examining in later chapters.
T H E RISK-R E TUR N TR A D E - OFF

Figure 1.11 shows our findings on risk and return from Figure 1.9. What Figure 1.11 shows
is that there is a risk-return trade-off. At one extreme, if we are unwilling to bear any risk at
all, but we are willing to forgo the use of our money for a while, then we can earn the risk-
free rate. Because the risk-free rate represents compensation for just waiting, it is often called
the time value of money.
If we are willing to bear risk, then we can expect to earn a risk premium, at least on aver-
age. Further, the more risk we are willing to bear, the greater is the risk premium. Investment
advisors like to say that an investment has a “wait” component and a “worry” component.
In our figure, the time value of money is the compensation for waiting and the risk premium
is the compensation for worrying.
There are two important caveats to this discussion. First, risky investments do not
always pay more than risk-free investments. Indeed, that is precisely what makes them
risky. In other words, there is a risk premium on average, but over any particular time
interval, there is no guarantee. Second, we have intentionally been a little imprecise about
Risk-Return Trade-Off
FIGURE 1.11
20
18 Small-company stocks
16
Average annual return (%)
14
12
10
8
6
T-bonds
4
T-bills
2
0
0 5 10 15 20 25 30 35 40
Annual return standard deviation (%)
what we mean exactly by risk. As we will discuss in the chapters ahead, investors are not
compensated for all risks. Some risks are cheaply and easily avoidable, and no reward
is expected for bearing them. It is only those risks that cannot be easily avoided that are
compensated (on average).
A LOOK AHE A D
In the remainder of this text, we focus almost exclusively on financial assets. An advantage
of this approach is that it is limited to four major types: stocks, bonds, futures, and options, in
the order that we cover them. This means that we will not be discussing collectibles such as
classic automobiles, baseball cards, coins, fine art, or stamps. Also, we will not be discussing
real estate or precious metals in great detail. It’s not that these are unimportant; rather, they
are very specialized. So, instead of treating them superficially, we leave a discussion of them
for another day (and another book).
As we’ve indicated, to understand the potential reward from an investment, it is critical to
first understand the risk involved. There is an old saying that goes like this: It’s easy to make
a small fortune investing in _____ (put your favorite investment here)—just start with a large
fortune! The moral is that the key to successful investing is to make informed, intelligent deci-
sions about risk. For this reason, we are going to pay particular attention to the factors that
determine the value of the different assets we discuss and the nature of the associated risks.
One common characteristic that these assets have is that they are bought and sold around
the clock and around the world in vast quantities. The way they are traded can be very dif-
ferent, however. We think it is important and interesting to understand exactly what happens
when you buy or sell one of these assets, so we will be discussing the different trading
mechanisms and the way the different markets function. We will also describe actual buying
and selling at various points along the way to show you the steps involved and the results of
placing buy and sell orders and having them executed.
1.7 Summary and Conclusions

This chapter presents some important concepts for investors, including the following items—
grouped by the chapter’s important concepts.
1. How to calculate the return on an investment using different methods.
A. We show how to calculate dollar returns and percentage returns over a time period.
Returns have two parts: a capital gain (or loss) and dividend income. We also show
how to convert returns over a period different from a year into annualized returns.
B. We demonstrate the two ways to calculate average returns over time: the arithmetic
method and the geometric method. The arithmetic average return answers the ques-
tion “What was your return in an average year over a particular period?” The geomet-
ric average return answers the question “What was your average compound return per
year over a particular period?” Generally, when investors say “average return,” they
are referring to arithmetic average unless they explicitly say otherwise.
C. We also examine the effect of fund flows into and out of an investment. This case
calls for calculating the dollar-weighted average return.
2. The historical returns on various important types of investments.
A. In order of their historical return from highest to lowest, we discuss returns on some
important portfolios, including
∙ Small-company stocks. This is a portfolio composed of the smallest (in terms of
total market value of outstanding stock) of the companies listed on major U.S.
exchanges.
∙ Large-company stocks. This portfolio is based on the Standard & Poor’s 500
index. This index contains 500 of the largest companies (in terms of total market
value of outstanding stock) in the United States.

∙ Long-term U.S. government bonds. This is a portfolio of U.S. government bonds
with 20 years to maturity.
∙ U.S. Treasury bills. This is a portfolio of Treasury bills (T-bills for short) with a
three-month maturity.
B. One important historical return fact is that U.S. T-bill returns have barely outpaced
inflation. Therefore, an investor must invest in stocks or bonds to earn a return higher
than the inflation rate.
3. The historical risks on various important types of investments.
A. Historically, the risk (as measured by standard deviation of returns) of the portfolios
described above is highest for small-company stocks. The next highest risk is for
large-company stocks, followed by long-term government bonds and Treasury bills.
B. We draw two key lessons from historical risk:
∙ Risky assets, on average, earn a risk premium. That is, there is a reward for
bearing risk. However, this expected reward is not realized each year.
∙ The greater the potential reward from a risky investment is, the greater the risk is.
4. The relationship between risk and return.
A. When we put these two key lessons together, we concluded that there is a risk-return
trade-off.
B. The only way to earn a higher return is to take on greater risk.
+ + + + + GETTING DOWN TO BUSINESS

This chapter took you through some basic, but important, investment-related calcula-
tions. We then walked through the modern history of risk and return. How should you, as
an investor or investment manager, put this information to work?
The answer is that you now have a rational, objective basis for thinking about what
you stand to make from investing in some important broad asset classes. For the stock
market as a whole, as measured by the performance of large-company stocks, you know
that you might realistically expect to make about 12 percent or so per year on average.
For the latest information Equally important, you know that you won’t make 12 percent in any one year; instead,
on the real world of you’ll make more or less. You know that the standard deviation is about 20 percent
investments, visit us at per year, and you should know what that means in terms of risk. In particular, you need
jmdinvestments.blogspot.com. to understand that in one year out of every six, you should expect to lose more than
8 percent (12 percent minus one standard deviation), so this will be a relatively common
event. The good news is that in one year out of six, you can realistically expect to earn
more than 32 percent (12 percent plus one standard deviation).
The other important, practical thing to understand from this chapter is that a strategy
of investing in very-low-risk assets (such as T-bills) has historically barely kept up with
inflation. This might be sufficient for some investors, but if your goal is to do better than
that, then you will have to bear some amount of risk to achieve it.
Key Terms
arithmetic average return 25 risk-free rate 15
capital gains yield 4 risk premium 15
dividend yield 4 standard deviation 17
dollar-weighted average return 28 total dollar return 3
effective annual return (EAR) 6 total percent return 4
geometric average return 25 variance 17
normal distribution 20
Chapter Review Problems and Self-Test
1. Calculating Returns (CFA1) You bought 400 shares of Metallica Heavy Metal, Inc., at
$30 per share. Over the year, you received $0.75 per share in dividends. If the stock sold for
$33 at the end of the year, what was your dollar return? Your percentage return?
2. Calculating Returns and Variability (CFA2) Using the following returns, calculate the
arithmetic average returns, the variances, the standard deviations, and the geometric returns for
the following stocks:
Year Michele, Inc. Janicek Co.
1 12% 5%
2 −4 −15
3 0 10
4 20 38
5 2 17
3. Forecasting Returns Over a 30-year period, an asset had an arithmetic return of 12.8 percent
and a geometric return of 10.7 percent. Using Blume’s formula, what is your best estimate of the
future annual returns over the next 5 years? 10 years? 20 years?
Answers to Self-Test Problems

1. Your dollar return is just your gain or loss in dollars. Here, we receive $0.75 in dividends on
each of our 400 shares, for a total of $300. In addition, each share rose from $30 to $33, so we
make $3 × 400 shares = $1,200. Our total dollar return is thus $300 + $1,200 = $1,500.
Our percentage return (or just “return” for short) is equal to the $1,500 we made divided
by our initial outlay of $30 × 400 shares = $12,000; so $1,500/12,000 = 0.125 = 12.5%.
Equivalently, we could have just noted that each share paid a $0.75 dividend and each share
gained $3, so the total dollar gain per share was $3.75. As a percentage of the cost of one share
($30), we get $3.75/30 = 0.125 = 12.5%.
2. First, calculate arithmetic averages as follows:
Michele, Inc. Janicek Co.
12% 5%
−4 −15
0 10
20 38
2 17
30% 55%
Average return: 30/5 = 6% 55/5 = 11%
Using the arithmetic averages above, calculate the squared deviations from the arithmetic
average returns and sum the squared deviations as follows:
Michele, Inc. Janicek Co.
(12 − 6)2 = 36 (5 − 11)2 = 36

(−4 − 6)2 = 100 (−15 − 11)2 = 676
(0 − 6)2 = 36 (10 − 11)2 = 1
(20 − 6) = 196
2
(38 − 11) = 729
2
(2 − 6)2 = 16 (17 − 11)2 = 36

384 1,478

Calculate return variances by dividing the sums of squared deviations by four, which is the
number of returns less one.
Michele: 384 / 4 = 96 Janicek: 1,478 / 4 = 369.5
Standard deviations are then calculated as the square root of the variance.
___ _____
Michele: √ 96   = 9.8% Janicek: √ 369.5   
= 19.22%
Geometric returns are then calculated as
Michele: [(1 + 0.12)(1 − 0.04)(1 + 0.00)(1 + 0.20)(1 + 0.02)]1/5 − 1 = 5.65%

Janicek: [(1 + 0.05)(1 − 0.15)(1 + 0.10)(1 + 0.38)(1 + 0.17)]1/5 − 1 = 9.65%
3. To find the best forecast, we apply Blume’s formula as follows:
R(5) = (_____
  5 − 1
  × 10.7%
 
  ) + (  29  × 12.8%
30 − 5 
______  ) = 12.51%
29
R(10) = (______
  10 − 1
  × 10.7%
 
  ) + (  29  × 12.8%
30 − 10 
_______  ) = 12.15%
29
R(20) = (______
  20 − 1
  × 10.7%
 
  ) + (  29  × 12.8%
30 − 20 
_______   ) = 11.42%
29
Test Your Investment Quotient
IQ
1. Prices and Returns (LO1, CFA1) You plan to buy a common stock and hold it for one year.
You expect to receive both $1.50 from dividends and $26 from the sale of the stock at the end of
the year. If you wanted to earn a 15 percent rate of return, what is the maximum price you would
pay for the stock today?
$22.61
a.
$23.91
b.
$24.50
c.
$27.50
d.
2. Returns (LO1, CFA1) A portfolio of non-dividend-paying stocks earned a geometric
mean return of 5 percent between January 1, 2010, and December 31, 2016. The arithmetic
mean return for the same period was 6 percent. If the market value of the portfolio at the
beginning of 2010 was $100,000, the market value of the portfolio at the end of 2016 was
closest to
$135,000
a.
$140,710
b.
$142,000
c.
$150,363
d.
3. Standard Deviation (LO4, CFA2) Which of the following statements about standard devia-
tion is true? Standard deviation
Is the square of the variance.
a.
Can be a positive or negative number.
b.
Is denominated in the same units as the original data.
c.
Is the arithmetic mean of the squared deviations from the mean.
d.
4. Normal Distribution (LO4, CFA3) An investment strategy has an expected return of
12 percent and a standard deviation of 10 percent. If the investment returns are normally
distributed, the probability of earning a return less than 2 percent is closest to
10 percent
a.
16 percent
b.
32 percent
c.
34 percent
d.
5. Normal Distribution (LO4, CFA3) What are the mean and standard deviation of a standard
normal distribution?
Mean Standard Deviation

0
a. 0
0
b. 1
1
c. 0
1
d. 1
6. Normal Distribution (LO4, CFA3) Given a data series that is normally distributed with a
mean of 100 and a standard deviation of 10, about 95 percent of the numbers in the series will
fall within which of the following ranges?
60 to 140
a.
70 to 130
b.
80 to 120
c.
90 to 110
d.
7. Asset Types (LO3) Stocks, bonds, options, and futures are the four major types of
Debt
a.
Real assets
b.
Equity
c.
Financial assets
d.
8. Investment Returns (LO1, CFA1) Suppose the value of an investment doubles in a one-
year period. In this case, the rate of return on this investment over that one-year period is what
amount?
100 percent even if the gain is not actually realized.
a.
200 percent even if the gain is not actually realized.
b.
100 percent only if the gain is actually realized.
c.
200 percent only if the gain is actually realized.
d.
9. Historical Returns (LO2) Which of the following asset categories has an annual returns
history most closely linked to historical annual rates of inflation?
U.S. Treasury bills
a.
Corporate bonds
b.
c.
d.
10. Historical Returns (LO2) Based on the annual returns history since 1926, which asset
category, on average, has yielded the highest risk premium?
U.S. government bonds
a.
Corporate bonds
b.
c.
d.
11. Stat 101 (LO1, CFA1) Over a four-year period, an investment in Outa’synch common stock
yields returns of −10, 40, 0, and 20. What is the arithmetic return over this period?
5 percent
a.
7.5 percent
b.
10 percent
c.
12.5 percent
d.
12. Stat 101 (LO4, CFA3) You calculate an average historical return of 20 percent and a
standard deviation of return of 10 percent for an investment in Stonehenge Construction Co.
You believe these values well represent the future distribution of returns. Assuming that
returns are normally distributed, what is the probability that Stonehenge Construction will
yield a negative return?
17 percent
a.
33 percent
b.
5 percent
c.
2.5 percent
d.

13. Stat 101 (LO4, CFA3) Which of the following statements about a normal distribution is
incorrect?
A normal distribution is symmetrically centered on its mean.
a.
The probability of being within one standard deviation from the mean is about 68 percent.
b.
The probability of being within two standard deviations from the mean is about
c.
95 percent.
The probability of a negative value is always one-half.
d.
14. Normal Distribution (LO4, CFA3) Based on a normal distribution with a mean of 500 and a
standard deviation of 150, the z-value for an observation of 200 is closest to
−2.00
a.
−1.75
b.
1.75
c.
2.00
d.
15. Normal Distribution (LO4, CFA2) A normal distribution would least likely be described as
Asymptotic.
a.
A discrete probability distribution.
b.
A symmetrical or bell-shaped distribution.
c.
A curve that theoretically extends from negative infinity to positive infinity.
d.
Concept Questions
1. Risk versus Return (LO3, CFA2) Based on the historical record, rank the following invest-
ments in increasing order of risk. Rank the investments in increasing order of average returns.
What do you conclude about the relationship between the risk of an investment and the return
you expect to earn on it?
Large stocks
a.
Treasury bills
b.
Long-term government bonds
c.
Small stocks
d.
2. Return Calculations (LO1, CFA1) A particular stock had a return last year of 4 percent.
However, you look at the stock price and notice that it actually didn’t change at all last year.
How is this possible?
3. Returns Distributions (LO4, CFA2) What is the probability that the return on small stocks
will be less than −100 percent in a single year (think about it)? What are the implications for
the distribution of returns?
4. Arithmetic versus Geometric Returns (LO1, CFA1) What is the difference between
arithmetic and geometric returns? Suppose you have invested in a stock for the last 10 years.
Which number is more important to you, the arithmetic or geometric return?
5. Blume’s Formula (LO1) What is Blume’s formula? When would you want to use it in
practice?
6. Inflation and Returns (LO1, CFA2) Look at Table 1.1 and Figures 1.5 and 1.6. When were
T-bill rates at their highest? Why do you think they were so high during this period?
7. Inflation and Returns (LO1, CFA2) The returns we have examined are not adjusted for infla-
tion. What do you suppose would happen to our estimated risk premiums if we did account for
inflation?
8. Taxes and Returns (LO1) The returns we have examined are not adjusted for taxes. What do
you suppose would happen to our estimated returns and risk premiums if we did account for
taxes? What would happen to our volatility measures?
9. Taxes and Treasury Bills (LO1) As a practical matter, most of the return you earn from invest-
ing in Treasury bills is taxed right away as ordinary income. Thus, if you are in a 40 percent tax
bracket and you earn 5 percent on a Treasury bill, your after-tax return is only 0.05 ×
(1 − 0.40) = 0.03, or 3 percent. In other words, 40 percent of your return goes to pay taxes,
leaving you with just 3 percent. Once you consider inflation and taxes, how does the long-term
return from Treasury bills look?
10. The Long Run (LO4, CFA2) Given your answer to the last question and the discussion in the
chapter, why would any rational person do anything other than load up on 100 percent small stocks?
Questions and Problems

Core Questions 1. Calculating Returns (LO1, CFA1) Suppose you bought 100 shares of stock at an initial
price of $37 per share. The stock paid a dividend of $0.28 per share during the following
year, and the share price at the end of the year was $41. Compute your total dollar return on
this investment. Does your answer change if you keep the stock instead of selling it? Why or
why not?
2. Calculating Yields (LO1, CFA1) In Problem 1, what is the capital gains yield? The dividend
yield? What is the total rate of return on the investment?
3. Calculating Returns (LO1, CFA1) Rework Problems 1 and 2 assuming that you buy 500
shares of the stock and the ending share price is $34.
4. Historical Returns (LO3) What is the historical rate of return on each of the following
investments? What is the historical risk premium on these investments?
Long-term government bonds
a.
Treasury bills
b.
Large stocks
c.
Small stocks
d.
5. Calculating Average Returns (LO1, CFA1) The rates of return on Cherry Jalopies,
Inc., stock over the last five years were 17 percent, 11 percent, −2 percent, 3 percent, and
14 percent. Over the same period, the returns on Straw Construction Company’s stock were 16
percent, 18 percent, −6 percent, 1 percent, and 22 percent. What was the arithmetic average
return on each stock over this period?
6. Calculating Variability (LO4, CFA2) Using the information from Problem 5, calculate the
variances and the standard deviations for Cherry and Straw.
7. Return Calculations (LO1, CFA1) A particular stock has a dividend yield of 1.2 percent.
Last year, the stock price fell from $65 to $59. What was the return for the year?
8. Geometric Returns (LO1, CFA1) Using the information from Problem 5, what is the geo-
metric return for Cherry Jalopies, Inc.?
9. Arithmetic and Geometric Returns (LO1, CFA1) A stock has had returns of 21 percent,
12 percent, 7 percent, −13 percent, −4 percent, and 26 percent over the last six years. What are
the arithmetic and geometric returns for the stock?
Intermediate Questions 10. Returns and the Bell Curve (LO4, CFA3) An investment has an expected return of
11 percent per year with a standard deviation of 24 percent. Assuming that the returns on this
investment are at least roughly normally distributed, how frequently do you expect to earn
between −13 percent and 35 percent? How often do you expect to earn less than −13 percent?
11. Returns and the Bell Curve (LO4, CFA3) An investment has an expected return of
12 percent per year with a standard deviation of 6 percent. Assuming that the returns on
this investment are at least roughly normally distributed, how frequently do you expect to
lose money?
12. Using Returns Distributions (LO4, CFA2) Based on the historical record, if you invest in
long-term U.S. Treasury bonds, what is the approximate probability that your return will be
below −6.3 percent in a given year? What range of returns would you expect to see 95 percent
of the time? 99 percent of the time?
13. Using Returns Distributions (LO2, CFA2) Based on the historical record, what is the
approximate probability that an investment in small stocks will double in value in a single year?
How about triple in a single year?

14. Risk Premiums (LO2) Refer to Table 1.1 for large-company stock and T-bill returns for the
period 1973–1977:
Calculate the observed risk premium in each year for the common stocks.
a.
Calculate the average returns and the average risk premium over this period.
b.
Calculate the standard deviation of returns and the standard deviation of the risk premium.
c.
Is it possible that the observed risk premium can be negative? Explain how this can happen
d.
and what it means.
15. Geometric Return (LO1, CFA1) Your grandfather invested $1,000 in a stock 50 years
ago. Currently the value of his account is $324,000. What is his geometric return over this
period?
16. Forecasting Returns (LO1) You have found an asset with a 12.60 percent arithmetic average
return and a 10.24 percent geometric return. Your observation period is 40 years. What is your
best estimate of the return of the asset over the next 5 years? 10 years? 20 years?
17. Geometric Averages (LO2) Look back to Figure 1.1 and find the value of $1 invested in each
asset class over this 90-year period. Calculate the geometric return for small-company stocks,
large-company stocks, long-term government bonds, Treasury bills, and inflation.
18. Arithmetic and Geometric Returns (LO1, CFA1) A stock has returns of −9 percent,
17 percent, 9 percent, 14 percent, and −4 percent. What are the arithmetic and geometric
returns?
19. Arithmetic and Geometric Returns (LO1, CFA1) A stock has had the following year-end
prices and dividends:
Year Price Dividend
0 $13.25 —
1 15.61 $0.15
2 16.72 0.18
3 15.18 0.20
4 17.12 0.24
5 20.43 0.28
What are the arithmetic and geometric returns for the stock?
20. Arithmetic versus Geometric Returns (LO1, CFA1) You are given the returns for the
following three stocks:
Year Stock A Stock B Stock C
1 8% 3% −24%
2 8 13 37
3 8 7 14
4 8 5 9
5 8 12 4
Calculate the arithmetic return, geometric return, and standard deviation for each stock. Do you
notice anything about the relationship between an asset’s arithmetic return, standard deviation,
and geometric return? Do you think this relationship will always hold?
Spreadsheet Problems 21. Return and Standard Deviation (LO4, CFA2) The 1980s were a good decade for investors
in S&P 500 stocks. To find out how good, construct a spreadsheet that calculates the arithmetic
average return, variance, and standard deviation for the S&P 500 returns during the 1980s using
spreadsheet functions.
22. Dollar-Weighted Average Return (LO3, CFA6) Suppose that an investor opens an account
by investing $1,000. At the beginning of each of the next four years, he deposits an additional
$1,000 each year, and he then liquidates the account at the end of the total five-year period.
Suppose that the yearly returns in this account, beginning in year 1, are as follows: −9 percent,
17 percent, 9 percent, 14 percent, and −4 percent. Calculate the arithmetic and geometric aver-
age returns for this investment, and determine what the investor’s actual dollar-weighted average
return was for this five-year period. Why is the dollar-weighted average return higher or lower
than the geometric average return?
CFA Exam Review by Kaplan Schweser

[CFA1, CFA6]
Mega Marketing, an advertising firm specializing in the financial services industry, has just
hired Kinara Yamisaka. Ms. Yamisaka was a finance major in college and is a candidate for
the CFA program. She was hired to provide the firm with more depth in the area of investment
performance analysis.
Mega is preparing advertising information for Vega Funds Limited. Vega has provided the
following five-year annual return data, where year 5 is the most recent period:
Vega Funds Limited
Year Return
1 −10%
2 25
3 −5
4 30
5 5
To assess her understanding of returns, Ms. Yamisaka’s supervisor asks her to calculate a
number of different returns, including arithmetic, geometric, annualized, and money- (or dollar-)
weighted returns. He also asks her to determine the impact of the following cash flow scenarios
on Vega’s returns:
Cash Flows Scenario 1 Scenario 2 Scenario 3
Beginning market value $100 $100 $100

End of year 2 deposit (withdrawal) $0 $20 ($10)
1. What is Vega’s geometric average return over the five-year period?

7.85 percent
a.
9.00 percent
b.
15.14 percent
c.
2. What are Vega’s money- (or dollar-) weighted average returns over the five-year period for
Scenarios 2 and 3?
Scenario 2 Scenario 3
7.78%
a. 7.96%
7.96%
b. 7.78%
9.00%
c. 7.85%
3. Ms. Yamisaka has determined that the average monthly return of another Mega client was
1.63 percent during the past year. What is the annualized rate of return?
5.13 percent
a.
19.56 percent
b.
21.41 percent
c.

4. The return calculation method most appropriate for evaluating the performance of a portfolio
manager is
Holding period
a.
Geometric
b.
Money-weighted (or dollar-weighted)
c.
What’s on the Web?

1. Ticker Symbols Go to finance.yahoo.com and look up the ticker symbols for the following
companies: 3M Company, International Business Machines, Dell Computer, Advanced Micro
Devices, American Standard Company, and Bed Bath & Beyond.
2. Average Return and Standard Deviation Go to finance.yahoo.com and enter the ticker
symbol for your favorite stock. Now, look for the historical prices and find the monthly closing
stock price for the last six years. Calculate the annual arithmetic average return, the standard
deviation, and the geometric return for this period.
Stock-Trak Exercises
To access the Stock-Trak Exercise for this chapter, please visit the resource library site in Connect and
choose the corresponding chapter.

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PART 1

investor (maybe even one

CFA™ Exam Topics in this Chapter:

Total dollar return = $80 + $1,120 = $1,200

Chapter 1 A Brief History of Risk and Return3

P ERCEN TAGE R E TUR N S

Our favorite investments

capital gains yield Capital gains yield = (Pt + 1 − Pt ) /Pt(1.2)

Percentage return = Dividend yield + Capital gains yield(1.3)

EXAMPLE 1.1 Calculating Percentage Returns

Chapter 1 A Brief History of Risk and Return5

EXAMPLE 1.2 A “QWEST” for Returns

EXAMPLE 1.3 More Annualized Returns

CHECK 1.1a What are the two parts of total return?

1.2 The Historical Record

Chapter 1 A Brief History of Risk and Return7

10,000 Small-company stocks

Chapter 1 A Brief History of Risk and Return9

Year-to-Year Total Returns on Small-Company Stocks: 1926–2015

U.S. Treasury bills

Chapter 1 A Brief History of Risk and Return11

2008: THE B E A R G ROWL E D A N D I N V E STOR S HOWLE D

A Brief History of Risk and Return13

1.3 Average Returns: The First Lesson

Large-company stocks 11.9%

AVER AGE R E TUR N S: THE HI STOR I CA L R E C OR D

Chapter 1 A Brief History of Risk and Return15

United States $25.1 37.4% $26.3 38.7%

Source: World Federation of Exchanges Database, http://www.world-exchanges.org/home/index.php/statistics/

Large-company stocks 11.9% 8.3%

CHECK 1.3a What do we mean by excess return and risk premium?

1.4 Return Variability: The Second Lesson

FREQ UE NCY D I STR I B UTI ON S A N D VA R I A B I L I TY

Chapter 1 A Brief History of Risk and Return17

T H E H ISTOR ICA L VA R I A N C E A N D STA N DA R D D E V I AT I O N

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

1 0.10 0.04 0.06 0.0036

EXAMPLE 1.4 Calculating the Variance and Standard Deviation

2012 0.1600 0.0180

Chapter 1 A Brief History of Risk and Return19

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

2012 0.1600 0.1587 0.0013 0.000002

Large-Company Stocks Long-Term Government Bonds

Variance (σ2) 0.0488/3 = 0.01625 0.1061/3 = 0.03536

U.S. Treasury bills 3.6% 3.2%

Inflation 3.0% 4.1%

The Normal Distribution: Illustrated Returns Based on the Historical

Chapter 1 A Brief History of Risk and Return21

EXAMPLE 1.5 Investing in Growth Stocks

2008-10-13 9,387.61 936.42 1 1933-03-15 62.10 15.3%

2008-09-29 10,365.45 −777.68 1 1987-10-19 1,738.74 −22.6%

CHECK 1.4a In words, how do we calculate a variance? A standard deviation?

Chapter 1 A Brief History of Risk and Return23

1.5 More on Average Returns

ARIT HME TIC V E R SU S G E OME TR I C AV E R AG E S

CALC U L ATI N G G E OME TR I C AV E R AG E R E TUR N S

This formula tells us that four steps are required:

Chapter 1 A Brief History of Risk and Return25

Large-company stocks 9.9% 11.9% 20.0%

EXAMPLE 1.6 Calculating the Geometric Average Return

Year Large-Company Stocks Product

2012 16.00 1.1600

​Geometric average return = ​1.7701​​ ​ ⁄ ​​− 1 = 0.1534, or 15.34%​

Chapter 1 A Brief History of Risk and Return3

capital gains yield Capital gains yield = (Pt + 1 − Pt ) /Pt(1.2)

Percentage return = Dividend yield + Capital gains yield(1.3)

Chapter 1 A Brief History of Risk and Return5

Chapter 1 A Brief History of Risk and Return7

Chapter 1 A Brief History of Risk and Return9

Chapter 1 A Brief History of Risk and Return11

A Brief History of Risk and Return13

Chapter 1 A Brief History of Risk and Return15

Chapter 1 A Brief History of Risk and Return17

Chapter 1 A Brief History of Risk and Return19

Chapter 1 A Brief History of Risk and Return21

Chapter 1 A Brief History of Risk and Return23

Chapter 1 A Brief History of Risk and Return25

Geometric average return = 1.7701  ⁄ − 1 = 0.1534, or 15.34%

R(1) = (_____ ) + (  24  × 12%) = 12%

Chapter 1 A Brief History of Risk and Return27

R (T ) = (  × 9.9%) + ( × 11.9%)

Chapter 1 A Brief History of Risk and Return29

Chapter 1 A Brief History of Risk and Return31

Chapter 1 A Brief History of Risk and Return33

Chapter 1 A Brief History of Risk and Return35

Chapter 1 A Brief History of Risk and Return37

Chapter 1 A Brief History of Risk and Return39