12.3.

Average Returns: The first lesson

The average return refers to the simple mathematical average of a series of returns generated
over some time. With any set of numbers, an average return is calculated the same way a
simple average is calculated. The numbers are summed up into a single sum. It is then
divided by the number in the set.
There are several return measures and ways to calculate them, but one takes the sum of the
returns for the arithmetic average return and divides it by the number of returns, as follows:

Average Return = Sum of Returns/Number of Returns

The simple rate of growth is a function of the values or balances which begin and end. It is
determined by subtracting the end value from the start value and then dividing it by the start
value. The definition is read as follows:

Growth Rate = (BV-EV)/BV

BV represents Beginning Value, while EV represents the Ending Value.

EXAMPLE

One example of average return is the simple arithmetic mean. For instance, suppose an
investment returns the following annually over a period of five full years: 10%, 15%, 10%,
0%, and 5%. To calculate the average return for the investment over this five-year period, the
five annual returns are added together and then divided by 5. This produces an annual
average return of 8%.

Now, let’s look at a real-life example. Shares of Walmart returned 9.1% in 2014, lost 28.6%
in 2015, gained 12.8% in 2016, gained 42.9% in 2017, and lost 5.7% in 2018. The average
return of Walmart over those five years is 6.1%, or 30.5% divided by 5 years.

A. Risk-free rate:

The risk-free rate of return is the theoretical rate of return of an investment with zero risk.
The risk-free rate represents the interest an investor would expect from an absolutely risk-free
investment over a specified period of time.

The so-called "real" risk-free rate can be calculated by subtracting the current inflation rate
from the yield of the Treasury bond matching your investment duration.

In theory, the risk-free rate is the minimum return an investor expects for any investment
because they will not accept additional risk unless the potential rate of return is greater than
the risk-free rate. Determination of a proxy for the risk-free rate of return for a given situation
must consider the investor's home market, while negative interest rates can complicate the
issue.
In practice, however, a truly risk-free rate does not exist because even the safest investments
carry a very small amount of risk. 

The risk-free rate determines the return an investor can expect over a specified period of time
from an investment. The value of a risk-free rate is calculated by subtracting the current
inflation rate from the total yield of the treasury bond matching the investment duration. For
example, the Treasury Bond yields 2% for 10 years. Then, the investor would need to
consider 2% as the risk-free rate of return.

A formula is used to calculate the risk-free rate of return. The formula states as:

Risk-free Rate of Return = ( 1+Governmennt Bond Rate1+Inflation rate) – 1

Most of the time, the calculation of the risk-free rate of return depends on the time period that
is under evaluation. Suppose the time period is for one year or less than one year than one
should go for the most comparable government security, i.e., Treasury Bills. For example, if
the treasury bill quote is .389, then the risk-free rate is .39%.

If the time duration is in between one year to 10 years, then one should look for Treasury
Note. For Example: If the Treasury note quote is .704, then the calculation of the risk-free
rate will be 0.7%

Suppose the time period is more than one year than one should go for Treasury Bond. For
example, if the current quote is 7.09, then the calculation of the risk-free rate of return would
be 7.09%.

B. Risk premium:

A risk premium is the investment return an asset is expected to yield in excess of the risk-free
rate of return. An asset's risk premium is a form of compensation for investors. It represents
payment to investors for tolerating the extra risk in a given investment over that of a risk-free
asset.

A risk premium can be construed as a true earnings reward, because risky investments are
inherently more profitable should they succeed.

Risk premium= The difference between a risky invesment return and the risk- free rate

*Why Does a Risk Premium Exist?

• Modern investment theory centers on this question.

• Therefore, we will examine this question many times in the chapters ahead.

• However, we can examine part of this question by looking at the dispersion, or spread, of
historical returns.

• We use two statistical concepts to study this dispersion, or variability: variance and standard
deviation.
  The risk-free rate represents compensation for just waiting.

 Therefore, this is often called the time value of money.

The estimated return minus the return on a risk-free investment is equal to the risk premium.
For example, if the estimated return on an investment is 6 percent and the risk-free rate is 2
percent, then the risk premium is 4 percent. This is the amount that the investor hopes to earn
for making a risky investment.

C. The First Lesson

The First Lesson: There is a reward, on average, for bearing risk.

TABLE 12.3

Average Annual Returns: 1926–2016

  Average Return Risk Premium

Investment
Large Stocks 12.1% 8.6%
Small Stocks 16.9% 13.4%
Long-term Corporate Bonds 6.3% 2.8%

Long-term Government Bonds 5.9% 2.4%

U.S. Treasury Bills 3.5% 0.0%

SOURCE: Morningstar, 2017, author calculations.

Looking at Table 12.3, we see that the average risk premium earned by a typical large-
company stock is :12.0% − 3.4 = 8.6%. This 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 for bearing risk. there is a
reward that goes along with how much risk you're willing to talk all right and you need to
make sure that you are being rewarded appopriately for the commensurate level of risk that
you're talking.