What Determines the RequiredReturn on Investment Roi

A simpleanswer can be that theRequiredReturnDependson the Riskof theinvestment

The Greater the Risk the GreatertheRequiredReturn

ETURNS howto calculate theReturnfrominvesting

If youBuy an AssetyourGainor Lossfromthat investment iscalledtheReturn on yourInvestment
youmay receive some cashDirectlywhileyouown theinvestment

he Return Has 2 Components

income component
AprofitablecompanyMaychoose toDistributesomeof its profits to shareholders in theformof cashDividends

Capital Gain or Loss

The value of the Assetyoupurchase The changes in the value ofyourinvestmentwillResultin in a
will often change Capital Gain or Loss

Total Cash If Stock is sold Initial investment t Total Return

Total Cash If Stock is sold 3,700 518 4,218

Total Cash If Stock is sold Proceeds from Stock sale t Dividends

Total Cash If Stock is sold 40 33 100 185 4 218

TISTORICALRECORD OF RETURNS

arge Company stocks

Based on the S P 500index 500 of theLargestCompanies
in terms of Total Marketvalue of outstandingstock

mall Company Stocks

Smallest 20 of companies Listed on theNYSE
in terms of total Marketvalue of outstandingstock

Ong Term CorporateBonds notshown

HighQualityBondswith 20years to Maturity

Ong Term U S Government Bonds

US GovernmentBonds with 20years to Maturity

S Treasury Bills
TreasuryBills T Bills with one MonthMaturity

G PICTURELOOK
To Get Everythingon a singleGraph SomeModification in Scalingis used vertical Axis is scaled so that
EqualDistancesMeasureEqualpercentage as opposed to Changes Changes invalue

Small Cap Investment Did Best overall

LargecapinvestmentDid Less well
T Bill Grewonlyto 21 62 whichis Lessimpressivewhenyouconsider theinflation 14.34Wasneededto replaceth
original 1

WhyWouldAnyoneBuyAnythingother than Small Cap stocks

While T Bills Long Term GovernmentBondsgrewMoreslowlythan the stockportfoliosdidtheyGrewmuch
MoreSteadily WhileSmall StocksGrewQuiteErraticallyat times up loot down 50 t
RISK PREMIUM
SinceGovernmentissued securities are Freefrommuch of the variability we can use them as a Benchmark
we will useTreasuryBills with the shortest time toMaturityofDifferentGovernmentBonds as the Benchmark

Because the Government can alwaysRaisetaxes topayBills the DebtRepresented by T Bills isvirtuallyfreeof anyDefaul
over its short life

We will call the Rate ofReturnon suchDebt in this case T Bills The RiskFreePremium
The Differencebetween the Risk Free it is Excess because it is the AdditionalReturn
Return AnyotherReturn will be the we can Earn bymovingfrom a RelativelyRisk Free
ExcessReturn investment to a Risky one

Because it can be Interpreted as a RewardforBearingRisk We will call it RiskPremium

ARIABILITYOFRETURNS
Returns on common stocks tend to be More volatile than the Returns on GovernmentBonds now we want to
MeasureVariability
Frequency Distribution ofReturnsforLarge companystocks
FREQUENCYDISTRIBUTION

Drawing a frequency distribution of the LargeCap

StockReturns to see theNumber of times theAnnual
Return Falls Within Each 101 Range
ample 17 times in theRangeof lot to 201

ext we need to Measurethe spread in the Returns

Howmuch the ActualReturnDeviatesfrom the Average
Measurethe volatilityofReturns via the variance a standardDeviation
ARIANCE
measures the Average squaredDifferencebetween the
ActualReturns the AverageReturn
The Bigger the Numberis the more the ActualReturns
Tend to Differ fromthe AverageReturn A
te larger the variance or standardDeviation the
wore spread out the Returns will be
j

Notice that the standard Deviation for Small cap

stocks 31.5 per year is More than 10 times
Larger than T Bills Standard Deviation of 3.1t
Per year

NORMAL DISTRIBUTION
NormalDistributionfor describing the probability ofendingup in a GivenRange

The usefulness of the NormalDistribution is that its completelyDescribed by the Average StandardDeveation
The probability that you willEndup Theprobabilitythatyouwin
within onestandarddeveationofthe Endup within two standard
Average is About y Deveation of the Average
is about as t

standardDeveationsAwayfromthe Average
is Less than it
y
AssumingLargeCapstock areNormallyDistributed f
he Probability that theReturn in a Givenyear is
n the Rangeof 7.71 to 31 at There is 43 ChanceReturns will be outsidethisRange
121 I l 119.81 is about 3 or 68 soExpecttobeoutside thisRangein 1 yr outofevery3yrs
Therangeof 27.5 t to 51.71 12.1t I 2 19 81
ARITHMETIC VS GEOMETRIC AVERAGES

Geometric AverageReturns Will Always be Smaller

than Arithmetic Average Returns As long as they are
Not Identical

The Magnitudeof the Difference between Geometric

AverageReturns will be Larger for Morevolatile Investments ForLargecompany stocks
as Measured by HigherStandardDeviationsin this case 0.12 4210.19872 0.101398 to 14
I 10.2 t

Geometric AverageReturns are Approximately Equal to the

Arithmetic Average Minus Half the variance

Approximate GeometricAverageReturns ArithmeticAugReturn 42 Variance

Which Average Return to use when Forecasting Future Wealth Levels

if we know the true ArithmeticAverageReturns
then this is what we should use in our Forecast
 The problem is we usuallyonly have Estimates of Arithmetic GeometricReturn 2
Estimates have Errors

In this case ArithmeticAverageReturn is probablyTooHigh optimistic for Longerperiods t the

Geometric Average is probably Too low pessimistic for shorterperiods

BlumesFormula says ifyouare usingAveragecalculat

over aLongperiod to Forecast
up to a Decadeinto thefuturethenshoulduseArithmetic

FewDecadesinto thefuture asyoumightforRetirement

planning then youshould split the Difference betwe
Arithmetic GeometricAugReturns

ALongPeriodCoveringManyDecades then useGeome

Average

CAPITAL MARKET EFFICENCY

Capital Market History Suggests that the Market Pa Of the Answeris that New informationArrives
values of stocks Bonds CanFluctuateWidelyfrom investors Re Assess AssetvaluesbasedonthatInformat

year to year

A Questionthat hasReceivedAttention is whetherPricesAdjust Quickly Correctlywhen newinformationArrives

The market is said to be Efficent if this in an Efficent CapitalMarket
is the case CurrentMarketPricesFullyReflect
Availableinformation
meaning Based on Availableinformation there is noReason toBelieve that the current price is too low orToobig

here are 3 Possible Stock Adjustments

EfficentReaction cent overreaction

price Adjustsimmediately to the price over Adjuststo th
New Information
n g p
No Further Changes
III
fullyabsorb the information Newinformation
it over shoots the New
price subsequentlyCorrea
 Nextet Len

As a Result In An Efficient Market Investors getExactly what they pay for when theyBuySecurities
Firms ReceiveExactly What their Stocks Bonds are worth whenthey sell them

What Makes a Market Efficent is the CompetitionAmongInvestors as they try to Find Mis pricedSto

with more information Gathering Analysis Mis priced stocks will become Fewer 2 Fewer
Makingthe Market increasingly Efficent
you think you have found a pattern instock or a strategy forpickingwinner youprobablyHaveNot

An EquilibriumComesintobeing where there is JustEnough Mis pricingaround for those who are Best at identif
to Make a Living at it
For Most otherinvestors the Activity ofinformationGathering Analysis will Not pay

Market Efficiency Implies that the price a Firm will obtain when it sells a share of its stock is a
Fair price in the sense that it reflects the value of that stock Given the information Availableaboutthe Firm

Shareholders Do Not have to worry thatthey arepayingtoo much for a stockwithLowDividendorsomeothersort of

Characteristicbecause the market has Alreadyincorporated that characteristicinto theprice
we say that theinformationhas beenpricedout

ow can theMarketbeEfficient If Stockprices are FluctuatingfromDaytoDay

Pricemovements are in Nowayinconsistent with Efficency
Rather investorsareBombardedwithinformationEveryDay
PriceFluctuation is a reflectionof informationFlow
S prices are Right thenwhyDotheychangesomuch t sooften
An Absenceof pricemovements in a world
that changes asRapidly as ours would
Suggestinefficiency

EPENDING ON THE DEGREE OF EFFICENCY WESAYTHAT MARKETS AREEITHER

Weak FormEfficent semi strongEfficent strongFormEfficent

At Minimum the current Allpublicinformationis All information of Everykind
price of a stockReflectsthe Reflected in thestockprice isReflected in stockprices

socisownpaspriczygyggggggg

yy

WHAT DOES CAPITALMARKET HISTORYSAYABOUTMARKETEfficiency

rices RespondRapidly Un PredictableFuture Difficult to Detect

pricesappear to RespondRapidly to
Newinformation
TheResponseis atLeastNotGrossly
Differentfromwhat we wouldExpect
in a EfficentMarket
Thefuture of Marketprices If mis pricedstockExists then
particularlyin theShort Runis there is noobviousmeans of
Difficult topredictbasedon identifyingthem
publiclyAvailableInformation

Simple Mindedschemes Based on publicinformationwillprobably not be successful