Measuring Return
• Return is a measure of how well a security performs as
Lecture 10
Measuring Return
Return: Example
• Buy a stock at the beginning of the year for $50
• At the end of the year it pays $2 dividend
• At the end of the year, the ex-dividend price is
$55
• Gross return = (2+55)/50=1.14
• Net return = (2+55-50)/50 = 0.14 = 14%
• Income yield = 2/50 = 0.04 = 4%
• Capital gain = (55-50)/50 = 0.10 = 10%
Compounding Return
• Similarly, if an investment doubles your money
over a decade, the gross return over the decade
is 2
• The annualized return is 21/10 = 1.072
• An annual return of 7.2% will double your money
if it is repeated each year for ten years.
an investment.
Pt Dt+1 Pt+1
Time t Time t+1
• Gross return = (Dt+1+Pt+1)/Pt = 1+Rt+1
• Net return = (Dt+1+Pt+1-Pt)/Pt = Rt+1
• Net return = income yield + capital gain
= Dt+1/Pt +(Pt+1-Pt)/Pt .
Compounding Return
• By convention, we often report returns on an annual
basis (at an annual rate), even if the period over which
we calculate return is different from a year
• This convention facilitates return comparisons
• The correct way to do this is to raise the gross return to a
power
• Example: this quarter a stock has a return of 8%
• The gross return this quarter is 1.08
• If this same gross return were repeated for four quarters,
the return after a year would be (1.08)4 =1.36
• Thus the annualized return is 36% (NOT 32% = 4 x 8%).
Lower Bound on Return
• For assets with limited liability, the worst that can
happen is that you lose your initial investment
• In this case, the gross return is zero and the net
return is -1 = -100%
• For such assets, we can define the log return as
the natural log of the gross return
• But some assets do not have limited liability:
– Insurance participation at Lloyds of London
– Companies with legal liabilities taken over by new
owners with deep pockets
– Short positions
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 Log return and compounding
Consider a compounded return
1+R= If this same gross return were repeated for
four quarters, the return after a year would be
(1.08)4
Log return=ln((1+R)4)=ln((1.08)4)=4*ln(1.08)
Geometric Average Return
Which Average Is Better?
It depends on your purpose.
• G is a good summary of past performance, since it
depends only on the cumulative return earned over the
sample period used to compute the average
• Under the reasonable assumption that log returns are
symmetric, G gives the median of the return distribution.
Half the time you will do better, half the time worse than
G.
• Under the reasonable assumption that log returns are
symmetric with a single peak, G gives the mode of the
return distribution, the single most likely outcome.
Arithmetic Average Return
What’s the Difference?
Which Average Is Better?
It depends on your purpose.
• A is the expected return if you hold the asset for a single
randomly selected period.
• If each period’s return is a new draw from the same
return distribution, then the expected gross return if you
hold the asset for K periods (the K-period “buy and hold”
return) is (1+A)K. This is greater than (1+G)K.
• Relative to A, G penalizes returns for risk. The penalty is
exactly the right one for an investor with log utility of
wealth. Such an investor chooses the portfolio with
maximum G.
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 Portfolio Return
• The return on a portfolio is a weighted average
of the returns on the individual assets in the
portfolio
Portfolios and Indexes • The weights in this average are the fractions of
the value of the portfolio that is invested in each
asset. These are called portfolio weights.

Index Construction Index Construction

• An index is a portfolio that is thought to be representative • Equal-weighted indexes place most of their
of the general market.
weight on small companies. Equal-weighted
• Each index is described by the included assets and the
weights placed on each asset. portfolios require frequent trading (why?)
• Alternative weighting schemes: • Value-weighted indexes summarize the fortunes
– Equal-weighted, wi = 1/n. of all the dollars invested in the index
– Price-weighted, wi = Pi/(P1 + … + Pn). Example: Dow Jones
Industrial Average. constituents. Value-weighted portfolios never
– Value-weighted, wi = Vi/(V1 + … + Vn), where Vi = market value = need to be rebalanced (why?)
price per share x number of shares outstanding. Example: S&P
500. • Price-weighted indexes are bizarre and exist
– Free-float-weighted. Same as value-weighted except that only by historical accident.
market value calculation excludes shares that are not traded.
Example: Morgan Stanley Capital International (MSCI) indexes
of foreign stocks.

Stocks, Bonds, Bills, and Gold Stocks, Bonds, Bills, and Gold
Real Cumulative Returns
• The return history fits the basic story of 1000
S&P500
equilibrium with risk aversion 10-year T-bonds
• Stocks do well when the economy does well, 100
1-month T-bills
Gold
and have the highest average return
Value ($)

• Gold does well when the economy does poorly, 10

and has the lowest average return
• Bonds and bills are intermediate
1
1925

1930

1935

1940

1945

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

0.1
Time

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 Does the Measurement Interval
Matter?
• By convention, we report returns on an annualized basis
• Does the measurement interval matter? For example,
does it matter whether we calculate the average using
monthly data and then annualize, or using annual data
directly?
Does the Measurement Interval
Matter?
• So mean and variance scale in proportion to the
measurement interval, implying that g and a both scale
in proportion as well
• When you annualize g and a you undo this effect and get
numbers that do not depend on the measurement
interval
• The measurement interval does not matter!
• But note the assumption we had to make to get this
result: returns in each period are uncorrelated with
returns in other periods. We will come back to this later
in the course
Which Average Is Better?
It depends on your purpose.
• G is a good summary of past performance, since it
depends only on the cumulative return earned over the
sample period used to compute the average
• Under the reasonable assumption that log returns are
symmetric, G gives the median of the return distribution.
Half the time you will do better, half the time worse than
G.
• Under the reasonable assumption that log returns are
symmetric with a single peak, G gives the mode of the
return distribution, the single most likely outcome.
Does the Measurement Interval
Matter?
• If returns in each period are uncorrelated with returns in
other periods, then the measurement interval does not
matter
• To see this, look at g, the average of log returns
• The log return over two periods is the sum of two
successive log returns, rt + rt+1
• Thus the mean of the two-period return is twice the
mean of the one-period return
• The variance of the two-period return is twice the
variance of the one-period return:
Var(rt + rt+1) = Var(rt) + Var(rt+1) + 2Cov(rt, rt+1) = 2Var(rt)
because the covariance term is zero by assumption
Normality
• For most asset returns, log returns are approximately
normal over periods of a month or more
• Why? Because monthly returns are generated by
multiplying daily returns within the month
• Thus monthly log returns are generated by adding daily
returns within the month
• These daily returns are approximately independent
• The Central Limit Theorem says that sums of
independent random variables approach the normal
distribution, no matter what the distribution of the
underlying daily shocks
Which Average Is Better?
It depends on your purpose.
• A is the expected return if you hold the asset for a single
randomly selected period.
• If each period’s return is a new draw from the same
return distribution, then the expected gross return if you
hold the asset for K periods (the K-period “buy and hold”
return) is (1+A)K. This is greater than (1+G)K.
• Relative to A, G penalizes returns for risk. The penalty is
exactly the right one for an investor with log utility of
wealth. Such an investor chooses the portfolio with
maximum G.