Chapter 12 Some Lessons from Capital Market History Returns the greater the potential reward it the greater the risk if you buy an asset of any sort your gain from that investment is called return on your investment o o income component cash you receive capital gain loss change in the value of the asset total dollar return dividend income capital gain or loss Total cash if stock is sold initial investment total return Percentage Return Dividend yield Dividend paid initial price of stock capital gains yield change in price initial price Total percentage return dividend yield capital gains yield The Historical Record large company stocks S P 500 largest 500 companies in the US long term gov t bonds based on high quality bonds with 20 years to maturity 1 2 3 US Treasury bills based on T bills with a one month maturity Average Returns Calculating Average Returns add up yearly returns and divide by number of years risk premium excess return required from an investment in a risky asset over that required from a risk free investment the extra return for taking on risk treasury bills have virtually no risk there is a risk free return excess return additional return we earn by moving to a riskier investment o o o o calculated by taking average return of an investment minus the average return on US Treasury bill Variability of Returns variance average squared difference between the actual return and the average return o o the bigger the variance the more the actual returns tend to differ from the average return to calculate Add up all the deviations AND divide by the number of returns LESS ONE n 1 find the average return sum of numbers amount of terms subtract the actual return from the average AND then square it gives you a deviation o Variance actual average 2 n 1 standard deviation square root of the variation More about Average Returns o 1 R1 x 1 R2 1 T 1 o T years of returns o R each annual return o sum of returns years Capital Market Efficiency geometric average return average compound return earned per ear over a multiyear period tells you what you actually earned per year on average compounded annually arithmetic average return return earned in an average year over a multiyear tells you what you earned in a typical year efficient capital market market in which security prices reflect available information o a market is efficient when prices adjust correctly when new info arrives efficient markets hypothesis actual capital markets NYSE are efficient Common Misconceptions about EMH Efficient markets do not mean that you can t make money On average you will earn a return that is appropriate for the risk undertaken Market efficiency will not protect you from wrong choices if you do not diversify Forms of Market Efficiency strong form ALL information public private is reflected in stock prices semi strong form prices reflect all publicly available information including trading information annual reports press releases weak form prices reflect all past market information such as price and volume