FI 311 – Spring 2023 Module 3 – Risk and Reward Chapter 6: Some Lessons from Capital Market History CHAPTER THEMES • Importance of Financial Markets • Risk/Reward Tradeoff • Historical Returns of Various Investment Style Categories • Risk Premium • Standard Deviation • Efficient Markets The Importance of Financial Markets Recall from Chapter 1: Investments involve a re-allocation of capital from those that have money they don’t currently need to those that need money they don’t currently have. The importance of any market is that it more efficiently brings buyers and sellers together; financial markets bring sellers of securities and investors together: • Investors can allocate capital to issuers of securities (borrowers) to make it grow so that they will have more money to spend when they are ready to spend it. • Borrowers can use the money they otherwise wouldn’t have to grow their enterprise (or in the case of governmental entities, accomplish some goal they otherwise wouldn’t be able to do). The Importance of Financial Markets Financial markets also provide us with information about the risk and reward characteristics of various investments, i.e. what levels of return are investors looking for at given levels of risk. Some lessons we have learned from observing capital markets: – There is a reward for bearing risk (or should be) – The greater the potential reward, the greater the risk – This is called the risk-reward trade-off The Risk/Reward Tradeoff Also recall from Chapter 1 our definitions of risk and reward: • Risk is the possibility of losing something or being in a worse condition • In Finance, Risk is the possibility of losing money • Reward is the money you receive, or hope to receive, for putting your resources at risk • Return is reward expressed as a percentage of what was invested The tradeoff is: • If you take on more risk, you should demand a higher reward, but: • If you are not willing to take on risk, you must be willing to accept a lower reward. Successful investing is about maximizing your return for any given level of risk. Stocks, Bond, Bills and Inflation Stocks Large Cap Small Cap Bonds Average Returns (1926-2018) Investment Category Small company stocks Large company stocks Long-term Corporate bonds Long-term Government bonds 30-day Treasury Bills Consumer Price Inflation Annual Return 1926-2018 11.8% 10.0% 5.9% 5.5% 3.3% 2.9% Risk Premium The Risk Premium is a measure of how much extra a risky investment or group of risky investments is expected to return over something which entails no risk at all. It is essentially the reward for taking on risk. • Treasury bills are considered to be risk-free. • The risk premium is the expected or realized return over and above the risk-free rate. Therefore, the Risk Premium for any asset or investment category is it’s historical or expected return minus the Treasury Bill rate. Average Annual Returns and Risk Premiums Investment Category Small company stocks Large company stocks Long-term Corporate bonds Long-term Government bonds 30-day Treasury Bills Consumer Price Inflation Annual Return 11.8% 10.0% 5.9% 5.5% 3.3% 2.9% Risk Premium 8.5% 6.7% 2.6% 2.2% n/a n/a Variance and Standard Deviation Variance and standard deviation measure the volatility of asset returns. • The greater the volatility, the greater the uncertainty • Historical variance = sum of squared deviations from the mean / (number of observations – 1) • Standard deviation = square root of the variance We will use Standard Deviation as a proxy for the quantified level of risk of many assets, except individual stocks as we will see later in this Module. Average Annual Returns and Standard Deviation Investment Category Small company stocks Large company stocks Long-term Corporate bonds Long-term Government bonds 30-day Treasury Bills Consumer Price Inflation Annual Return 11.8% 10.0% 5.9% 5.5% 3.3% 2.9% Standard Deviation 31.6% 19.8% 8.4% 9.8% 3.1% 4.0% Risk/Return Recap Risk Level Asset Type Stocks Bonds Higher Stocks Small Corporate Lower Bonds Large Government Efficient Capital Markets In a purely efficient market, all securities are priced (buying and selling for) their true, or intrinsic, value. • If this is true, then you should not be able to earn excess returns above those of the broader market. • Numerous studies over time have shown the 80-90% of professional investors, including mutual fund managers, fail to beat the broad market or index tied to their investment style. • Efficient markets DO NOT imply that investors cannot earn a positive return in the stock market. This theory implies that you cannot “beat” the market. Stock Price Reactions What Makes Markets Efficient? There are many investors as well as professional investment analysts out there doing research, using the same publicly available information • As new information comes to market, this information is analyzed and trades are made based on this information • Therefore, prices should reflect all available public information • While many investors come up with the wrong valuation of individual investments, in the aggregate the consensus estimates tend to be fairly accurate over the long-term. Empirical evidence suggests that markets are very efficient over the long-term, but not very efficient in the short-term. Short-term price movements are heavily influenced by emotion, whereas fundamentals tend to drive prices over the long-term. Common Misconceptions about EMH • Efficient markets do not mean that you can’t make money in investment markets. • They do mean that, on average, you will earn a return that is appropriate for the risk undertaken and there is not a bias in prices that can be exploited to earn excess returns • Market efficiency will not protect you from wrong choices if you do not diversify – you still don’t want to “put all your eggs in one basket” Implications of Market Efficiency 1. Stock prices respond very rapidly to new information 2. Future prices are very difficult to predict based on publicly available information (financial statements, disclosures, etc.) 3. It is very difficult for the average investor (and professionals) to identify and exploit mispriced stocks. 4. Financial managers cannot time stock and bond sales. 5. Clearly, the market is not perfectly efficient, especially in the short-term.
