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Investment
Analysis & Analysis &
Portfolio Portfolio

Investment Analysis &

Portfolio Management
Management Management

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 F r e q u e n t ly U s e d S y m b o l s a n d T e r m s

a alpha coefficient, a measure of a portfolio’s k required rate of return.

“value added” return. £ pound (United Kingdom currency).
ABS asset-backed securities. NAV net asset value.
APT arbitrage pricing theory. OAS option-adjusted spread.
AUM assets under management. P price of a share of stock or put option; P0 is
b beta coefficient, a measure of an asset’s the current price.
systematic riskiness. P/BV price/book value ratio.
C call option value. P/CF price/cash flow ratio.
CAPM capital asset pricing model. P/E price/earnings ratio.
CAR cumulative average residuals. PPP purchasing power parity.
CF cash flow; CFt is cash flow in period t. P/S price/sales ratio.
CML capital market line. PV present value.
Covij covariance of the returns between assets i PVIF present value interest factor for a lump
and j. sum.
D dividend per share of stock; Dt is dividend PVIFA present value interest factor for an annuity.
per share during period t. rij correlation coefficient between assets i
Dp Macaulay duration measure of portfolio p. and j.
DDM dividend discount model. RFR rate of return on a risk-free asset.
€ euro currency. ROA return on assets.
EBIT earnings before interest and taxes. ROE return on equity.
EBITDA earnings before interest, taxes, deprecia- RR fraction of a firm’s earnings retained rather
tion, and amortization. than paid out. It is equal to (I – D/E),
EMH efficient market hypothesis. where D/E is the ratio of dividends (D) to­
EPS earnings per share. earnings (E).
E(R) expected return; E(Rt)is the expected Sp Sharpe ratio portfolio performance
­return during period t. measure.
ETY equivalent taxable yield. SMB size (“small minus big”) risk factor.
F futures or forward contract delivery price. SML security market line.
FV future value. Σ summation sign (capital sigma).
FVIF future value interest factor for a lump sum. s standard deviation (lowercase sigma).
FVIFA future value interest factor for an annuity. sij covariance between returns for security i
FX foreign exchange. and j.
GM geometric mean. t tax rate or time when used as a subscript
g growth rate in earnings, dividends, or (e.g., Dt is the dividend in a year t).
stock prices. T time to expiration.
h hedge ratio. TE tracking error.
HML value-growth (“high minus low”) risk factor. V value of an asset; Vj is the value of asset j.
HPR holding period return. Wi proportion of portfolio invested in asset i.
HPY holding period yield. WACC weighted average cost of capital.
I rate of inflation. E(I) is the expected rate X option of exercise price.
of inflation. ¥ yen (Japanese currency).
IRp information ratio portfolio performance YTC yield to call.
measure. YTM yield to maturity.
MBS mortgage-backed securities.
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Investment Analysis &
Portfolio Management
ELEVENTH EDITION

FRANK K. REILLY
University of Notre Dame

KEITH C. BROWN
University of Texas at Austin

SANFORD J. LEEDS
University of Texas at Austin

Australia Brazil Mexico Singapore United Kingdom United States

 Investment Analysis & Portfolio
Management, Eleventh Edition
Frank K. Reilly, Keith C. Brown, and
Sanford J. Leeds
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 To my best friend & wife,
Therese,
and the greatest gifts and
sources of our happiness,
Frank K. III, Charlotte, and Lauren
Clarence R. II, Michelle, Sophie, and Cara
Therese B. and Denise Z.
Edgar B., Lisa, Kayleigh, Madison J. T., Francesca, and Alessandra
—F. K. R.

To Sheryl, Alexander, and Andrew, who make it all worthwhile

—K. C. B.

To Jenny, Jay, John, and Genet, who bring meaning and happiness to my life.
—S. J. L.
Brief Contents
Preface xi
Acknowledgments xvii
About the Authors xxi

PART 1 The Investment Background 1

CHAPTER 1 The Investment Setting 3
CHAPTER 2 Asset Allocation and Security Selection 33
CHAPTER 3 Organization and Functioning of Securities Markets 69
CHAPTER 4 Security Market Indexes and Index Funds 95

PART 2 Developments in Investment Theory 123

CHAPTER 5 Efficient Capital Markets, Behavioral Finance, and
Technical Analysis 125
CHAPTER 6 An Introduction to Portfolio Management 171
CHAPTER 7 Asset Pricing Models 209

PART 3 Valuation and Management of Common Stocks 249

CHAPTER 8 Equity Valuation 251
CHAPTER 9 The Top-Down Approach to Market, Industry, and
Company Analysis 295
CHAPTER 10 The Practice of Fundamental Investing 343
CHAPTER 11 Equity Portfolio Management Strategies 379

PART 4 Valuation and Management of Bonds 421

CHAPTER 12 Bond Fundamentals and Valuation 423
CHAPTER 13 Bond Analysis and Portfolio Management Strategies 465

PART 5 Derivative Security Analysis 517

CHAPTER 14 An Introduction to Derivative Markets and Securities 519
CHAPTER 15 Forward, Futures, and Swap Contracts 559
CHAPTER 16 Option Contracts 603

iv
 Brief Contents v

PART 6 Analysis and Evaluation of Asset Management 645

CHAPTER 17 Professional Portfolio Management, Alternative Assets,
and Industry Ethics 647
CHAPTER 18 Evaluation of Portfolio Performance 693
Appendix A The CFA® Charter 741
Appendix B Code of Ethics and Standards of Professional
Conduct 743
Appendix C Interest Tables 745
Appendix D Standard Normal Probabilities 749
Comprehensive References List 750
Glossary 762
Index 774
Contents
Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xi
Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xvii
About the Authors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xxi
PART 1 The Investment Background 1
CHAPTER 1
The Investment Setting . . . . . . . . . . . . . . . . . . . . . . . . . 3
What Is an Investment? 3 World Portfolio Performance 56, Art and Antiques 59,
Investment Defined 4
Measures of Return and Risk 5
Measures of Historical Rates of Return 5, Computing
Mean Historical Returns 7, Calculating Expected Rates of
Return 10, Measuring the Risk of Expected Rates of
Return 12, Risk Measures for Historical Returns 14
Determinants of Required Rates of Return 14
The Real Risk-Free Rate 15, Factors Influencing the
Nominal Risk-Free Rate (NRFR) 16, Risk Premium 18,
Risk Premium and Portfolio Theory 20, Fundamental
Risk versus Systematic Risk 21, Summary of Required
Rate of Return 21
Relationship between Risk and Return 22
Movements along the SML 22, Changes in the Slope of
the SML 23, Changes in Capital Market Conditions or
Expected Inflation 24, Summary of Changes in the
Required Rate of Return 26
Chapter 1 Appendix: Computation of Variance and Standard
Deviation 30
CHAPTER 2
Asset Allocation and Security Selection . . . . . . . . . 33
Individual Investor Life Cycle 34
The Preliminaries 34, Investment Strategies over an
Investor’s Lifetime 35, Life Cycle Investment Goals 36
The Portfolio Management Process
The Need for a Policy Statement 38
Understanding and Articulating Realistic Investor Goals
38, Standards for Evaluating Portfolio Performance 39,
Other Benefits 39
Input to the Policy Statement 40
Investment Objectives 40, Investment Constraints 42
Constructing the Policy Statement 44
General Guidelines 44, Some Common Mistakes 44
vi
The Importance of Asset Allocation 44
Investment Returns after Taxes and Inflation 46, Returns
and Risks of Different Asset Classes 46, Asset Allocation
Summary 48
The Case for Global Investments 49
Relative Size of U.S. Financial Markets 50, Rates of Return
on U.S. and Foreign Securities 51, Risk of Diversified
Country Investments 51
Historical Risk-Returns on Alternative Investments 56
Real Estate 60
Chapter 2 Appendix:
A. Covariance 67
B. Correlation 67
CHAPTER 3
Organization and Functioning of Securities
Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
What Is a Market? 70
Characteristics of a Good Market 70, Decimal Pricing 71,
Organization of the Securities Market 71
Primary Capital Markets 72
Government Bond Issues 72, Municipal Bond Issues 72,
Corporate Bond Issues 72, Corporate Stock Issues 73,
Private Placements and Rule 144A 74
Secondary Financial Markets 74
Why Secondary Markets Are Important 75, Secondary
Bond Markets 75, Financial Futures 75, Secondary Equity
Markets 76, Exchange Market-Makers 78
Classification of U.S. Secondary Equity Markets 78
Primary Listing Markets 78, The Significant Transition of
the U.S. Equity Markets 80
Alternative Types of Orders Available 85
Market Orders 85, Limit Orders 86, Special Orders 86,
Margin Transactions 86, Short Sales 88, Exchange Merger
37 Mania 90
CHAPTER 4
Security Market Indexes and Index Funds . . . . . . 95
Uses of Security Market Indexes 96
Differentiating Factors in Constructing Market
Indexes 97
The Sample 97, Weighting Sample Members 97,
Computational Procedure 97

Stock Market Indexes 97
Price-Weighted Index 98, Value-Weighted Index 99,
Unweighted Index 101, Fundamental Weighted Index
102, Style Indexes 102, Global Equity Indexes 103
Bond Market Indexes 107
U.S. Investment-Grade Bond Indexes 109, High-Yield
Bond Indexes 109, Global Government Bond Indexes 109
Composite Stock–Bond Indexes 109
Comparison of Indexes over Time 110
Correlations between Monthly Equity Price Changes 111,
Correlations between Monthly Bond Index Returns 111
Investing in Security Market Indexes 112
Chapter 4 Appendix: Stock Market Indexes 119
PART 2 Developments in
Investment Theory 123
CHAPTER 5
Efficient Capital Markets, Behavioral
Finance, and Technical Analysis . . . . . . . . . . . . 125
Efficient Capital Markets 126
Why Should Capital Markets Be Efficient? 126,
Alternative Efficient Market Hypotheses 127, Tests and
Results of Efficient Market Hypotheses 128
Behavioral Finance 142
Explaining Biases 143, Fusion Investing 144
Implications of Efficient Capital Markets 144
Efficient Markets and Fundamental Analysis 144, Efficient
Markets and Portfolio Management 146
Technical Analysis 148
Underlying Assumptions of Technical Analysis 149
Advantages of Technical Analysis 151
Challenges to Technical Analysis 152
Challenges to the Assumptions of Technical Analysis 152,
Challenges to Specific Trading Rules 152
Technical Trading Rules and Indicators 153
Contrary-Opinion Rules 154, Follow the Smart Money
155, Momentum Indicators 156, Stock Price and Volume
Techniques 157, Efficient Markets and Technical
Analysis 163
CHAPTER 6
An Introduction to Portfolio Management . . . . . 171
Some Background Assumptions 171
Risk Aversion 172, Definition of Risk 172
The Markowitz Portfolio Theory 172
Alternative Measures of Risk 173, Expected Rates of
Return 173, Variance (Standard Deviation) of Returns for
Contents vii
an Individual Investment 174, Variance (Standard
Deviation) of Returns for a Portfolio 175, Standard
Deviation of a Portfolio 180, A Three-Asset Portfolio 187,
Estimation Issues 188
The Efficient Frontier 189
The Efficient Frontier: An Example 189, The Efficient
Frontier and Investor Utility 191
Capital Market Theory: An Overview 193
Background for Capital Market Theory 193, Developing
the Capital Market Line 193, Risk, Diversification, and the
Market Portfolio 197, Investing with the CML: An
Example 200
Chapter 6 Appendix:
A. Proof That Minimum Portfolio Variance Occurs with Equal
Investment Weights When Securities Have Equal
Variance 207
B. Derivation of Investment Weights That Will Give Zero
Variance When Correlation Equals 1.00 207
CHAPTER 7
Asset Pricing Models . . . . . . . . . . . . . . . . . . . . . . . . . 209
The Capital Asset Pricing Model 209
A Conceptual Development of the CAPM 210, The
Security Market Line 211
Empirical Tests of the CAPM 218
Stability of Beta 218, Relationship between Systematic
Risk and Return 219, Additional Issues 219, Summary of
Empirical Results for the CAPM 220
The Market Portfolio: Theory versus Practice 221
Arbitrage Pricing Theory 223
Using the APT 224, Security Valuation with the APT: An
Example 226, Empirical Tests of the APT 228
Multifactor Models and Risk Estimation 229
Multifactor Models in Practice 230, Estimating Risk in a
Multifactor Setting: Examples 235
PART 3 Valuation and Management
of Common Stocks 249
CHAPTER 8
Equity Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251
Important Distinctions 251
Fairly Valued, Overvalued, and Undervalued 251,
Top-Down Approach versus Bottom-Up Approach 252
An Introduction to Discounted Cash Flow and Relative
Valuation 254
The Foundations of Discounted Cash Flow Valuation 255,
The Constant Growth Model 256, The No-Growth Model
259, Multistage (or Two-Stage) Growth Assumption 260
viii Contents

Discounted Cash Flow 261 Calculating Intrinsic Value 330

Method #1: The Dividend Discount Model 261, Method
#2: Free Cash Flow to Equity—The Improved DDM 265,
Method #3: Discounted Cash Flow (FCFF) 272
Relative Valuation 279
Implementing Relative Valuation 280, Relative Valuation
with CSCO 283, Advantages of Multiples 285,
Disadvantages of Multiples 285
Ratio Analysis 285
Growth Rate of Sales 286, Gross Margins 286, Operating
Margins 286, Net Margins 287, Accounts Receivable
Turnover 287, Inventory Turnover 287, Net PP&E
Turnover 287, Debt as a Percentage of Long-Term Capital
287, Changes in Reserve Accounts 288, Operating
Earnings/GAAP Earnings 288
The Quality of Financial Statements 288
Balance Sheet 288, Income Statement 289, Footnotes 289
Moving on to Chapter 9 289
Chapter 8 Appendix: Derivation of Constant-Growth Dividend
Discount Model (DDM) 293
CHAPTER 9
The Top-Down Approach to Market, Industry, and
Company Analysis . . . . . . . . . . . . . . . . . . . . . . . . . 295
Introduction to Market Analysis 296
Aggregate Market Analysis (Macroanalysis) 298
Leading, Coincident, and Lagging Indicators 299,
Sentiment and Expectations Surveys 303, Interest Rates
303
Microvaluation Analysis 308
FCFE to Value the Market 309, Multiplier Approach 313,
Shiller P/E Ratio 314, Macrovaluation and Microvaluation
of World Markets 315
Introduction to Industry Analysis: Why Industry Analysis
Matters 316
Industry Analysis 318
The Business Cycle and Industry Sectors 318, Structural
Economic Changes Impact the Industry (Noncyclical
Factors) 319, Industry Life Cycle 320, Industry
Competition 320
Estimating Industry Rates of Return 322
Estimating the Cost of Capital 322, Sales Growth
Estimates 324, Other Considerations 324
Global Industry Analysis 324
Company Analysis 325
Growth Companies and Growth Stocks 325, Defensive
Companies and Stocks 326, Cyclical Companies and
Stocks 326, Speculative Companies and Stocks 327, Value
versus Growth Investing 327
Connecting Industry Analysis to Company Analysis 327
Firm Competitive Strategies 328, SWOT Analysis 330
Some Additional Insights on Valuation—For Individual
Companies 330, Analyzing Growth Companies 331
Lessons from Some Legends 335
Some Lessons from Lynch 335, Tenets of Warren Buffett
335, Tenets of Howard Marks 336
CHAPTER 10
The Practice of Fundamental Investing . . . . . . . . 343
Initial Public Offerings 344
Why Go Public 344, The IPO Process 344, Underpricing
347, Market Stabilization 349, Reasons for Underpricing
349, Bookbuilt Offering versus Auction 351, Longer-Term
Performance of IPOs 352
Buy-Side Analysts and Sell-Side Analysts 353
Sell-Side Analysts 353, Buy-Side Analysts 354, Financial
Analyst Forecasting Literature 355, Snap Inc. IPO and
Analysts 356
Capital Allocation 357
The Seven Places That Capital Can Be Allocated 357,
Dividends versus Repurchases 362, What Do Investors
Want to See? 363
Corporate Governance 363
The Board of Directors 363, Anti-Takeover Provisions
364, Compensation 365
Creating a Stock Pitch 369
Air Lease Pitch 369, A Few Closing Points Concerning
Stock Pitches 371
Chapter 10 Appendix:
Why Air Lease Should Soon Be Flying High 375
The Plane Truth 376
CHAPTER 11
Equity Portfolio Management Strategies . . . . . . . 379
Passive versus Active Management 380
An Overview of Passive Equity Portfolio Management
Strategies 381
Index Portfolio Construction Techniques 382, Tracking
Error and Index Portfolio Construction 382, Methods of
Index Portfolio Investing 385
An Overview of Active Equity Portfolio Management
Strategies 388
Fundamental Strategies 389, Technical Strategies 390,
Factors, Attributes, and Anomalies 393, Forming
Momentum-Based Stock Portfolios: Two Examples 396,
Tax Efficiency and Active Equity Management 398,
Active Share and Measuring the Level of Active
Management 400
Value versus Growth Investing: A Closer Look 401
An Overview of Style Analysis 406

Asset Allocation Strategies 410
Integrated Asset Allocation 410, Strategic Asset Allocation
412, Tactical Asset Allocation 413, Insured Asset
Allocation 413
PART 4 Valuation and Management
of Bonds 421
CHAPTER 12
Bond Fundamentals and Valuation . . . . . . . . . . . . 423
Basic Features of a Bond 424
Bond Characteristics 424
The Global Bond Market Structure 426
Participating Issuers 426, Participating Investors 428,
Bond Ratings 428
Survey of Bond Issues 430
Domestic Government Bonds 430, Government Agency
Issues 432, Municipal Bonds 433, Corporate Bonds 434,
Nontraditional Bond Coupon Structures 437, High-Yield
Bonds 438, International Bonds 439
Bond Yield Curves 441
The Determinants of Bond Yields 441, Yield Curves and
the Term Structure of Interest Rates 443, Par versus Spot
Yield Curves 444, Yield Curves for Credit-Risky Bonds
446, Determining the Shape of the Term Structure 447
Bond Valuation 449
Par versus Spot Bond Valuation 450, Bond Valuation and
Yields with Semiannual Coupons 451, Relationship
between Bond Yields, Coupon Rates, and Bond Prices
453, Bond Valuation between Coupon Dates 455,
Computing Other Bond Yield Measures 457
CHAPTER 13
Bond Analysis and Portfolio Management Strategies
465
Bond Analysis Tools 466
Implied Forward Rates 466, Bond Duration 467, Bond
Convexity 471, Bonds with Embedded Options 474, Yield
Spread Analysis 475
An Overview of Bond Portfolio Management:
Performance, Style, and Strategy 477
Passive Management Strategies 479
Buy-and-Hold Strategy 480, Indexing Strategy 480, Bond
Indexing in Practice: An Example 481
Active Management Strategies 482
Interest Rate Anticipation 483, Credit Analysis 484,
Implementing an Active Bond Transaction 489, Active
Global Bond Investing: An Example 489
Core-Plus Management Strategies 492
Matched-Funding Management Strategies 493
Contents ix
Dedicated Portfolios 494, Immunization Strategies 495,
Horizon Matching 499
Contingent and Structured Management Strategies 501
Chapter 13 Appendix: Closed-Form Equation for Calculating
Macaulay Duration 515
PART 5 Derivative Security Analysis 517
CHAPTER 14
An Introduction to Derivative Markets and
Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519
Overview of Derivative Markets 520
The Language and Structure of Forward and Futures
Markets 521, Interpreting Futures Price Quotations:
An Example 522, The Language and Structure of
Option Markets 525, Interpreting Option Price
Quotations: An Example 526
Investing with Derivative Securities 528
The Basic Nature of Derivative Investing 528, Basic Payoff
and Profit Diagrams for Forward Contracts 531, Basic
Payoff and Profit Diagrams for Call and Put Options 533,
Option Profit Diagrams: An Example 536
The Relationship between Forward and Option
Contracts 538
Put–Call–Spot Parity 538, Put–Call Parity: An Example
540, Creating Synthetic Securities Using Put–Call Parity
541, Adjusting Put–Call–Spot Parity for Dividends 542,
Put–Call–Forward Parity 543
An Introduction to the Use of Derivatives in Portfolio
Management 545
Restructuring Asset Portfolios with Forward Contracts
545, Protecting Portfolio Value with Put Options 547, An
Alternative Way to Pay for a Protective Put 549
CHAPTER 15
Forward, Futures, and Swap Contracts . . . . . . . . 559
An Overview of Forward and Futures Trading 560
Futures Contract Mechanics 560, Comparing Forward
and Futures Contracts 564
Hedging with Forwards and Futures 565
Hedging and the Basis 565, Understanding Basis Risk 566,
Calculating the Optimal Hedge Ratio 566
Forward and Futures Contracts: Basic Valuation
Concepts 567
Valuing Forwards and Futures 567, The Relationship
between Spot and Forward Prices 569
Financial Forwards and Futures: Applications
and Strategies 570
Interest Rate Forwards and Futures 570, Long-Term
Interest Rate Futures 570, Short-Term Interest Rate
x Contents
Futures 573, Stock Index Futures 576, Currency Forwards
and Futures 580
OTC Forward Contracts 584
Interest Rate Contracts 584, Equity Index-Linked Swaps
590
Chapter 15 Appendix: Calculating Money Market Implied
Forward Rates 600
CHAPTER 16
Option Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . 603
An Overview of Option Markets and Contracts 604
Option Market Conventions 604, Price Quotations for
Exchange-Traded Options 605
The Fundamentals of Option Valuation 609
The Basic Approach 609, Improving Forecast Accuracy
611, The Binomial Option Pricing Model 614, The Black–
Scholes Valuation Model 616, Estimating Volatility 618,
Problems with Black–Scholes Valuation 620
Option Valuation: Extensions 621
Valuing European-Style Put Options 621, Valuing
Options on Dividend-Bearing Securities 622, Valuing
American-Style Options 623
Option Trading Strategies 625
Protective Put Options 625, Covered Call Options 627,
Straddles, Strips, and Straps 628, Strangles 629, Spreads
630, Range Forwards 633
Other Option Applications 634
Convertible Bonds 634, Credit Default Swaps 637
PART 6 Analysis and Evaluation
of Asset Management 645
CHAPTER 17
Professional Portfolio Management, Alternative
Assets, and Industry Ethics . . . . . . . . . . . . . . . . 647
The Asset Management Industry: Structure
and Evolution 648
Private Management and Advisory Firms 651
Investment Strategy at a Private Money Management
Firm 652
Organization and Management of Investment
Companies 654
Valuing Investment Company Shares 654, Closed-End
versus Open-End Investment Companies 654, Fund
Management Fees 657, Investment Company Portfolio
Objectives 657, Breakdown by Fund Characteristics 660,
Global Investment Companies 662, Mutual Fund
Organization and Strategy: An Example 662
Investing in Alternative Asset Classes 664
Hedge Funds 665, Characteristics of a Hedge Fund 666,
Hedge Fund Strategies 667, Risk Arbitrage Investing: A
Closer Look 669, Hedge Fund Performance 670, Private
Equity 672
Ethics and Regulation in the Professional Asset
Management Industry 679
Regulation in the Asset Management Industry 680,
Standards for Ethical Behavior 681, Examples of Ethical
Conflicts 683
What Do You Want from a Professional Asset
Manager? 684
CHAPTER 18
Evaluation of Portfolio Performance . . . . . . . . . . 693
The Two Questions of Performance Measurement 694
Simple Performance Measurement Techniques 695
Peer Group Comparisons 696, Portfolio Drawdown 696
Risk-Adjusted Portfolio Performance Measures 698
Sharpe Portfolio Performance Measure 698, Treynor
Portfolio Performance Measure 700, Jensen Portfolio
Performance Measure 702, Information Ratio
Performance Measure 703, Sortino Performance Measure
706, Summarizing the Risk-Adjusted Performance
Measures 707
Application of Portfolio Performance Measures 709
Holdings-Based Portfolio Performance Measures 715
Grinblatt–Titman Performance Measure 715,
Characteristic Selectivity Performance Measure 717
The Decomposition of Portfolio Returns 719
Performance Attribution Analysis 719, Fama Selectivity
Performance Measure 722
Factors That Affect Use of Performance Measures 724
Demonstration of the Global Benchmark Problem 725,
Implications of the Benchmark Problems 725, Required
Characteristics of Benchmarks 726
Reporting Investment Performance 727
Time-Weighted and Money-Weighted Returns 727,
Performance Presentation Standards 729
Appendix A The CFA® Charter . . . . . . . . . . . . . . . 741
Appendix B Code of Ethics and Standards of
Professional Conduct . . . . . . . . . . . . . . . . . . . . . . . 743
Appendix C Interest Tables . . . . . . . . . . . . . . . . . . . 745
Appendix D Standard Normal Probabilities . . . . . 749
Comprehensive References List . . . . . . . . . . . . . . . . 750
Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 762
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 774
 Preface
The pleasure of authoring a textbook comes from writing about a subject that we enjoy and
find exciting. As authors, we hope that we can pass on to the reader not only knowledge but
also the excitement that we feel for the topic. In addition, writing about investments brings an
added stimulant because the subject can affect the reader during his or her entire business
career and beyond. We hope that what readers derive from this course will help them enjoy
better lives through managing their financial resources properly.
The purpose of this book is to help you learn how to manage your money so you will
derive the maximum benefit from what you earn. To accomplish this purpose, you need to
learn about the many investment alternatives that are available today and, what is more
important, to develop a way of analyzing and thinking about investments that will remain
with you in the years ahead when new and different investment opportunities become
available.
Because of its dual purpose, the book mixes description and theory. The descriptive mate-
rial discusses available investment instruments and considers the purpose and operation of
capital markets in the United States and around the world. The theoretical portion details
how you should evaluate current investments and future opportunities to develop a portfolio
of investments that will satisfy your risk–return objectives. We feel that this marriage of theory
and practice in the exposition will serve you quite well in both your professional careers and
personal lives as investors.
Preparing this 11th edition has been challenging for at least two reasons. First, we continue
to experience rapid changes in the securities markets in terms of theory, new financial instru-
ments, innovative trading practices, and the effects of significant macroeconomic disruptions
and the numerous regulatory changes that inevitably follow. Second, capital markets are con-
tinuing to become very global in nature. Consequently, to ensure that you are prepared to
function in a global environment, almost every chapter discusses how investment practice or
theory is influenced by the globalization of investments and capital markets. This completely
integrated treatment is meant to ensure that you develop a broad mindset on investments
that will serve you well in the 21st century.

Intended Market
This text is addressed to both graduate and advanced undergraduate students who are looking
for an in-depth discussion of investments and portfolio management. The presentation of the
material is intended to be rigorous and empirical, without being overly quantitative. A proper
discussion of the modern developments in investments and portfolio theory must be rigorous.
The discussion of numerous empirical studies reflects the belief that it is essential for alterna-
tive investment theories to be exposed to the real world and be judged on the basis of how well
they help us understand and explain reality.

Key Features of the 11th Edition

When planning the 11th edition of Investment Analysis and Portfolio Management, we wanted
to retain its traditional strengths and capitalize on new developments in the investments area
to make it the most comprehensive and accessible investments textbook available. To achieve
that goal, we have made a number of modifications to this edition.

xi
xii Preface

First and foremost, we have considerably streamlined our presentation of the material from
previous editions. Most notably, we have been able to compress our treatment of these impor-
tant topics into 18 chapters, compared to the 25 chapters contained in the 10th edition.
Importantly, we have not removed any content that we consider vital to a thorough under-
standing of investment management; rather, we have condensed and rearranged our presenta-
tions in a more effective way. An example of this is the section on equity valuation and
management, which previously spanned six separate chapters but now is contained in
Chapters 8–11.
Second, the current edition maintains its unparalleled international coverage. Investing
knows no borders, and although the total integration of domestic and global investment
opportunities may seem to contradict the need for separate discussions of international issues,
it in fact makes the need for specific information on non-U.S. markets, instruments, conven-
tions, and techniques even more compelling.
Third, both technology and regulations have caused more significant changes during the
past decade in the functioning and organization of global security markets than during the
prior 50 years. Chapter 3 contains a detailed discussion of this evolution and the results for
global markets, and Chapter 2 describes how specific security innovations and asset allocation
practices have been affected by these changes.
Fourth, today’s investing environment includes derivative securities not as exotic anomalies
but as standard investment instruments. We felt that Investment Analysis and Portfolio
Management must reflect that reality. Consequently, our three chapters on derivatives
(Chapters 14–16) are written to provide the reader with an intuitive, clear discussion of the
different instruments, their markets, valuation, trading strategies, and general use as risk man-
agement and return enhancement tools.
Finally, we have updated and expanded the set of questions and problems at the end of
each chapter to provide more student practice on executing computations concerned with
more sophisticated investment problems. These problems are also available in an interactive
format through the online resource described below.

Major Content Changes in the 11th Edition

The text has been thoroughly updated for currency as well as condensed for the sake of brev-
ity. In addition to these time-related revisions, we have also made the following specific
changes to individual chapters:
Chapter 1 This introductory discussion has been revised and updated to reflect recent changes
in financial market conditions that impact the investment setting.
Chapter 2 This chapter has been completely reworked to combine the discussions of the asset
allocation process and the global security markets that had been spread over multiple chapters
in previous editions. After establishing the importance of the asset allocation decision to all
investors, we focus on the notion of global diversification and provide an updated study on
the variety of investment instruments available for the use of global investors, including global
index funds and country-specific exchange-traded funds (ETFs).
Chapter 3 Because of the continuing growth in trading volume handled by electronic commu-
nications networks (ECNs), this chapter continues to detail the significant changes in the mar-
ket as well as the results of this new environment. This includes a discussion on the continuing
changes on the NYSE during recent years. We also consider the rationale for the continuing
consolidation of global exchanges across asset classes of stocks, bonds, and derivatives. In addi-
tion, we document recent mergers and discuss several proposed and failed mergers. Finally, we
note that the corporate bond market continues to experience major changes in how and when
trades are reported and the number of bond issues involved.
 Preface xiii

Chapter 4 This chapter contains a discussion of fundamental weighted stock and bond
indexes that use sales and earnings to weight components rather than market value. Also
included is an updated analysis of the relationship among indexes and the myriad ways
that investors can actually commit their financial capital to capture the returns on various
indexes.
Chapter 5 New studies that both support the efficient market hypothesis and provide new evi-
dence of anomalies are examined in this chapter. There is also discussion of behavioral finance
and how it explains many of the anomalies, as well as a consideration of technical analysis.
Further, we discuss the implications of the recent changes in the cost of trading (considered
in Chapter 3) on some of the empirical results of prior studies.
Chapter 6 The development of modern portfolio theory, starting with a discussion of the risk
tolerance of the investor, has been considerably revised and updated in an effort to stress the
conceptual nature of the portfolio formation process. An extensive example of global portfolio
optimization has also been included. The chapter now concludes with an intuitive discussion
of the transition from Markowitz portfolio analysis to capital market theory and the develop-
ment of the capital market line (CML).
Chapter 7 This chapter has been extensively revised to consider the topic of how asset pricing
models evolved conceptually and how they are used by investors in practice. We begin with an
extensive discussion of the capital asset pricing model (CAPM) in a more intuitive way,
including how this model represents a natural progression from modern portfolio theory. We
then describe the theory and practice of using multifactor models of risk and expected return.
The connection between the arbitrage pricing theory (APT) and empirical implementations of
the APT continues to be stressed, both conceptually and with several revised examples using
style classification data.
Chapter 8 This is the first of three entirely new chapters focusing on equity analysis and valu-
ation. We begin with a discussion of how valuation theory is used in practice. We distinguish
between valuing the equity portion of the firm (FCFE) and valuing the entire firm (FCFF).
Importantly, we show how the sustainable growth formula can be used to estimate the per-
centage of earnings that can be considered to be free cash flow. In the section on relative valu-
ation, we focus on fundamental multiples so that students will consider the underlying drivers
of value.
Chapter 9 This chapter presents a study of the top-down approach to equity analysis and
introduces new material designed to link monetary policy and interest rates to stock prices.
Most importantly, we describe the importance of the real federal funds rate, the shape of the
yield curve, and the risk premium for BBB bonds (versus Treasury bonds). Later in the chap-
ter, we discuss how the Shiller P/E ratio (also known as the cyclically adjusted price–earnings
[CAPE] ratio) is applied to the overall market.
Chapter 10 In this completely new chapter we discuss several topics that students need to
understand if they intend to enter the asset management industry as a profession. We provide
a detailed description of the IPO process, the difference between the buy-side and sell-side,
and the importance of management’s capital allocation function. The chapter ends with a dis-
cussion of how to design and deliver a persuasive stock pitch.
Chapter 11 This chapter contains an enhanced discussion of the relative merits of passive versus
active management techniques for equity portfolio management, focusing on the important role
of tracking error. Expanded material on forming risk factor–based equity portfolios has been
introduced, along with additional analysis of other equity portfolio investment strategies, includ-
ing fundamental and technical approaches, as well as a detailed description of equity style
analysis.
xiv Preface

Chapter 12 This is the first of two new chapters that describe the information, tools, and
techniques necessary to analyze fixed-income securities and portfolios. We begin with a dis-
cussion of the myriad bond instruments available to global investors, including traditional
fixed-coupon securities from sovereign and corporate issuers, securities issued by
government-sponsored entities (GSEs), collateralized debt obligations (CDOs), and auction-
rate securities. We then develop the intuition and mechanics for how bonds are valued
under a variety of market conditions, as well as the relationship that must exist between
bond prices and bond yields.
Chapter 13 We continue our development of the quantitative toolkit required of successful
bond investors by developing the technical concepts of implied forward rates, duration, and
convexity. In particular, we discuss the importance of the duration statistic as a measure of
price volatility in terms of both designing and managing bond portfolios. The discussion at
the end of the chapter on bond portfolio management strategies has been enhanced and
revised to include comparisons of active and passive fixed-income strategies, as well as updated
examples of how the bond immunization process functions.
Chapter 14 Expanded discussions of the fundamentals associated with using derivative securi-
ties (interpreting price quotations, basic payoff diagrams, basic strategies) are included in this
chapter. We also provide updated examples of both basic and intermediate risk management
applications using derivative positions, as well as new material on how these contracts trade
in the marketplace.
Chapter 15 New and updated examples and applications are provided throughout the chapter,
emphasizing the role that forward and futures contracts play in managing exposures to equity,
fixed-income, and foreign exchange risk. Also included is an enhanced discussion of how
futures and forward markets are structured and operate, as well as how swap contracts can
be viewed as portfolios of forward agreements.
Chapter 16 Here we expand the discussion linking valuation and applications of call and put
options in the context of investment management. The chapter contains both new and
updated examples designed to illustrate how investors use options in practice as well as a dis-
cussion of the recent changes to options markets. We also include extensive discussions of two
other ways that options can be structured into other financial arrangements: convertible bonds
and credit default swaps.
Chapter 17 This chapter includes a revised and updated discussion of the organization and
participants in the professional asset management industry. Of particular note is an exten-
sive update of the structure and strategies employed by hedge funds as well as enhanced
analysis of how private equity funds function. The discussion of ethics and regulation in
the asset management industry that concludes the chapter has also been updated and
expanded.
Chapter 18 An updated and considerably expanded application of the performance measure-
ment techniques introduced throughout the chapter is provided, including new material
regarding the calculation of both simple and risk-adjusted performance measures. The discus-
sion emphasizes the two main questions of performance measurement, as well as how the con-
cept of downside risk can be incorporated into the evaluation process and the examination of
techniques that focus on the security holdings of a manager’s portfolio rather than the returns
that the portfolio generates.

Supplement Package
Preparation of the 11th edition provided the opportunity to enhance the supplement
products offered to instructors and students who use Investment Analysis and Portfolio
 Preface xv

Management. The result of this examination is a greatly improved package that provides more
than just basic answers and solutions. We are indebted to the supplement writers who devoted
their time, energy, and creativity to making this supplement package the best it has ever been.

Website
The text’s Website, which can be accessed through http://login.cengage.com, includes up-to-date
teaching and learning aids for instructors. The Instructor’s Manual, Test Bank, and PowerPoint
slides are available to instructors for download. If they choose to, instructors may post, on a
password-protected site only, the PowerPoint presentation for their students.
Instructor’s Manual
The Instructor’s Manual contains a brief outline of each chapter’s key concepts and equations,
which can be easily copied and distributed to students as a reference tool.

Test Bank
The Test Bank includes an extensive set of new questions and problems and complete solu-
tions to the testing material. The Test Bank is available through Cognero, an online, fully cus-
tomizable version of the Test Bank, which provides instructors with all the tools they need to
create, author/edit, and deliver multiple types of tests. Instructors can import questions directly
from the Test Bank, create their own questions, or edit existing questions.

Solutions Manual
This manual contains all the answers to the end-of-chapter questions and solutions to end-
of-chapter problems.

Lecture Presentation Software

A comprehensive set of PowerPoint slides is available. Corresponding with each chapter is a
self-contained presentation that covers all the key concepts, equations, and examples within
the chapter. The files can be used as is for an innovative, interactive class presentation.
Instructors who have access to Microsoft PowerPoint can modify the slides in any way they
wish, adding or deleting materials to match their needs.
MindTap: Empower Your Students
MindTap is a platform that propels students from memorization to mastery. It gives you com-
plete control of your course, so you can provide engaging content, challenge every learner, and
build student confidence. Customize interactive syllabi to emphasize priority topics, then add
your own material or notes to the eBook as desired. This outcomes-driven application gives
you the tools needed to empower students and boost both understanding and performance.

Access Everything You Need in One Place Cut down on prep with the preloaded and orga-
nized MindTap course materials. Teach more efficiently with interactive multimedia, assign-
ments, quizzes, and more. Give your students the power to read, listen, and study on their
phones, so they can learn on their terms.

Empower Students to Reach Their Potential Twelve distinct metrics give you actionable
insights into student engagement. Identify topics troubling your entire class and instantly com-
municate with those struggling. Students can track their scores to stay motivated towards their
goals. Together, you can be unstoppable.

Control Your Course—And Your Content Get the flexibility to reorder textbook chapters, add
your own notes, and embed a variety of content including Open Educational Resources (OER).
xvi Preface

Personalize course content to your students’ needs. They can even read your notes, add their own,
and highlight key text to aid their learning.

Get a Dedicated Team, Whenever You Need Them MindTap isn’t just a tool; it’s backed by
a personalized team eager to support you. We can help set up your course and tailor it to your
specific objectives, so you’ll be ready to make an impact from day one. Know we’ll be standing
by to help you and your students until the final day of the term.
 Acknowledgments
So many people have helped us in so many ways that we hesitate to list them, fearing that we may miss someone.
Accepting this risk, we will begin with the University of Notre Dame and the University of Texas at Austin
because of their direct support. We are fortunate to have had the following excellent reviewers for this edition as
well as for earlier ones:
JOHN ALEXANDER HSIU-LANG CHEN JOSEPH E. FINNERTY
Clemson University University of Illinois at Chicago University of Illinois
ROBERT ANGELL DOSOUNG CHOI HARRY FRIEDMAN
East Carolina University Gachon University New York University
GEORGE ARAGON ROBERT CLARK R. H. GILMER
Boston College Husson University University of Mississippi
BRIAN BELT JOHN CLINEBELL STEVEN GOLDSTEIN
University of Missouri-Kansas City University of Northern Colorado University of South Carolina
OMAR M. BENKATO DONALD L. DAVIS STEVEN GOLDSTEIN
Ball State University Golden Gate University Robinson-Humphrey
ARAND BHATTACHARYA JAMES D’MELLO KESHAV GUPTA
University of Cincinnati Western Michigan University Oklahoma State University
CAROL BILLINGHAM EUGENE F. DRZYCIMSKI SALLY A. HAMILTON
Central Michigan University University of Wisconsin–Oshkosh Santa Clara University
SUSAN BLOCK WILLIAM DUKES ERIC HIGGINS
University of California, Santa Texas Tech University Kansas State University
Barbara
JOHN DUNKELBERG RONALD HOFFMEISTER
GERALD A. BLUM Wake Forest University Arizona State University
Babson College
ERIC EMORY SHELLY HOWTON
PAUL BOLSTER Sacred Heart University Villanova University
Northeastern University
THOMAS EYSSELL RON HUTCHINS
ROBERT E. BROOKS University of Missouri–St. Louis Eastern Michigan University
University of Alabama
HEBER FARNSWORTH A. JAMES IFFLANDER
ROBERT J. BROWN Rice University Arizona State University
Harrisburg, Pennsylvania
JAMES FELLER STAN JACOBS
BOLONG CAO Middle Tennessee State University Central Washington University
Ohio University
EURICO FERREIRA KWANG JUN
CHARLES Q. CAO Clemson University Michigan State University
Pennsylvania State University
MICHAEL FERRI JAROSLAW KOMARYNSKY
ATREYA CHAKRABORTY John Carroll University Northern Illinois University
University of Massachusetts
GREG FILBECK MALEK LASHGARI
Boston
Penn State Behrend University of Hartford
xvii
xviii Acknowledgments

DANNY LITT JONATHAN OHN HAROLD STEVENSON

UCLA Bloomsburg University Arizona State University
MILES LIVINGSTON HENRY OPPENHEIMER LAWRENCE S. TAI
University of Florida University of Rhode Island Loyola Marymount College
CHRISTOPHER MA JOHN PEAVY KISHORE TANDON
Texas Tech University Southern Methodist University The City University of New York,
Baruch College
ANANTH MADHAVAN GEORGE PHILIPPATOS
University of California Berkeley University of Tennessee DRAGON TANG
University of Hong Kong
DAVINDER MALHOTRA GEORGE PINCHES
Thomas Jefferson University University of Missouri Kansas City DONALD THOMPSON
Georgia State University
STEVEN MANN ROSE PRASAD
University of South Carolina Central Michigan University DAVID E. UPTON
Virginia Commonwealth University
IQBAL MANSUR LAURIE PRATHER
Widener University University of Tennessee at E. THEODORE VEIT
Chattanooga Rollins College
ANDRAS MAROSI
University of Alberta GEORGE A. RACETTE PREMAL VORA
University of Oregon Penn State Harrisburg
LINDA MARTIN
Arizona State University MURLI RAJAN BRUCE WARDREP
University of Scranton East Carolina University
GEORGE MASON
University of Hartford NARENDAR V. RAO RICHARD S. WARR
Northeastern Illinois University North Carolina State University
JOHN MATHYS
DePaul University STEVE RICH ROBERT WEIGAND
Baylor University University of South Florida
MICHAEL MCBAIN
Marquette University BRUCE ROBIN RUSSELL R. WERMERS
Old Dominion University University of Maryland
DENNIS MCCONNELL
University of Maine JAMES ROSENFELD ROLF WUBBELS
Emory University New York University
JEANETTE MEDEWITZ
University of Nebraska–Omaha STANLEY D. RYALS ELEANOR XU
Investment Counsel, Inc. Seton Hall University
JACOB MICHAELSEN
University of California, Santa Cruz JIMMY SENTEZA YEXIAO XU
Drake University The University of Texas at Dallas
NICHOLAS MICHAS
Northern Illinois University SHEKAR SHETTY HONG YAN
University of South Dakota Shanghai Advanced Institute of
THOMAS W. MILLER JR.
Finance
University of Missouri–Columbia FREDERIC SHIPLEY
DePaul University SHENG-PING YANG
LALATENDU MISRA
Gustavas Adolphus College
University of Texas at San Antonio DOUGLAS SOUTHARD
Virginia Polytechnic Institute
MICHAEL MURRAY
LaCrosse, Wisconsin

We have received invaluable comments from academic associates, including Jim Gentry (University of Illinois),
David Chapman (University of Virginia), Amy Lipton (St. Joseph’s University), Donald Smith (Boston Univer-
sity), and David Wright (University of Wisconsin–Parkside). Our university colleagues have also been very helpful
 Acknowledgments xix

over the years: Rob Batallio and Mike Hemler (University of Notre Dame); and Laura Starks, William Way, and
Ken Wiles (University of Texas). Finally, we were once again blessed with bright, dedicated research assistants,
such as Aaron Lin and Vincent Ng (Notre Dame) as well as Adam Winegar (University of Texas).
We are convinced that professors who want to write a book that is academically respectable and relevant, as
well as realistic, require help from the “real world.” We have been fortunate to develop relationships with a num-
ber of individuals (including a growing number of former students) whom we consider our contacts with reality.
The following individuals have graciously provided important insights and material:
BRENT ADAMS KENNETH FISHER MARK KRITZMAN
Kyle Capital Fisher Investments Windham Capital Management
JAMES F. ARENS H. GIFFORD FONG MARTIN LEIBOWITZ
Trust Company of Oklahoma Gifford Fong Associates Morgan Stanley
RICK ASHCROFT MARTIN S. FRIDSON DOUGLAS R. LEMPEREUR
Robert W. Baird Lehmann, Livian, Fridson Advisors Franklin Templeton Investments
BRIAN BARES M. CHRISTOPHER GARMAN ROBERT LEVINE
Bares Capital Management Bank of America/Merrill Lynch Nomura Securities
CHAD BAUMLER KHALID GHAYUR GEORGE W. LONG
Nuance Investments GPS Funds LIM Advisors Ltd.
DAVID G. BOOTH BEN GIELE SCOTT LUMMER
Dimensional Fund Advisors, Inc. Gearpower Capital Savant Investment Group
GARY BRINSON WILLIAM J. HANK JOHN MAGINN
Brinson Foundation Moore Financial Corporation Maginn Associates
KEVIN CASEY RICK HANS SCOTT MALPASS
Casey Capital Fred’s Inc. University of Notre Dame
Endowment
STALEY CATES LEA B. HANSEN
Southeastern Asset Management Institute for Research of Public Policy JACK MALVEY
BNY Mellon Investment
DWIGHT D. CHURCHILL W. VAN HARLOW
Management
State Street Global Advisors Fidelity Investments
DOMINIC MARSHALL
ABBY JOSEPH COHEN BRITT HARRIS
Pacific Ridge Capital Partners
Goldman, Sachs University of Texas Investment
Management Company TODD MARTIN
ROBERT CONWAY
Timucuan Asset Management
Goldman, Sachs CRAIG HESTER
Luther King Capital Management JOSEPH MCALINDEN
ROBERT J. DAVIS
McAlinden Research Partners
Highland Capital JOANNE HILL
CBOE Vest RICHARD MCCABE
PHILIP DELANEY JR.
Bank of America/Merrill Lynch
Northern Trust Bank BRANDON HOLCOMB
Goldman, Sachs MICHAEL MCCOWIN
PAT DORSEY
State of Wisconsin Investment Board
Dorsey Asset Management JOHN W. JORDAN II
The Jordan Company MARK MCMEANS
FRANK J. FABOZZI
Brasada Capital
Journal of Portfolio Management ANDREW KALOTAY
Kalotay Associates OLEG MELENTYEV
PHILIP FERGUSON
Bank of America/Merrill Lynch
Salient Partners WARREN N. KOONTZ JR.
Jennison Associates
xx Acknowledgments

KENNETH MEYER PHILIP J. PURCELL III WARREN TENNANT

Lincoln Capital Management Continental Investors Abu Dhabi Investment Authority
JANET T. MILLER JACK PYCIK KEVIN TERHAAR
Rowland and Company Consultant Stairway Partners
BRIAN MOORE RON RYAN JOHN THORTON
U.S. Gypsum Corp. Asset Liability Management Stephens Investment Management
Group
SALVATOR MUOIO ROBERT F. SEMMENS JR.
SM Investors, LP Semmens Private Investments STEPHAN TOMPSETT
Andeavor
DAVID NELMS MICHAEL SHEARN
Discover Financial Services Time Value of Money L.P. JOSE RAMON VALENTE
Econsult
GEORGE NOYES BRIAN SINGER
Hanover Strategic Management William Blair & Co. WILLIAM M. WADDEN
Wadden Enterprises
WILL O’HARA CLAY SINGLETON
University of Texas Rollins College RICHARD S. WILSON
Consultant
IAN ROSSA O’REILLY FRED H. SPEECE JR.
Canadian Foundation for Speece, Thorson Capital Group ARNOLD WOOD
Advancement of Investor Rights Martingale Asset Management
JAMES STORK
ROBERT PARRINO Pinnacle Financial Group BRUCE ZIMMERMAN
University of Texas Private Investor

We continue to benefit from the help and consideration of the dedicated people who have been associated
with the CFA Institute: Tom Bowman, Whit Broome, Jeff Diermeier, Bob Johnson, and Katie Sherrerd. Professor
Reilly would also like to thank his assistant, Rachel Karnafel, who had the unenviable task of keeping his office
and his life in some sort of order during this project.
As always, our greatest gratitude is to our families—past, present, and future. Our parents gave us life and
helped us understand love and how to give it. Most important are our wives who provide love, understanding,
and support throughout the day and night. We thank God for our children and grandchildren who ensure that
our lives are full of love, laughs, and excitement.
Frank K. Reilly
Notre Dame, Indiana

Keith C. Brown
Austin, Texas

Sanford J. Leeds
Austin, Texas

December 2017
 About the Authors

Frank K. Reilly is the Bernard J. Hank Professor of Finance and former dean of the Mendoza
College of Business at the University of Notre Dame. Holding degrees from the University of
Notre Dame (BBA), Northwestern University (MBA), and the University of Chicago (PhD), Pro-
fessor Reilly has taught at the University of Illinois, the University of Kansas, and the University
of Wyoming in addition to the University of Notre Dame. He has several years of experience as
a senior securities analyst, as well as experience in stock and bond trading. A chartered financial
analyst (CFA), he has been a member of the Council of Examiners, the Council on Education
and Research, the grading committee, and was chairman of the board of trustees of the Institute
of Charted Financial Analysts and chairman of the board of the Association of Investment Man-
agement and Research (AIMR; now the CFA Institute). Professor Reilly has been president of
the Financial Management Association, the Midwest Business Administration Association, the
Eastern Finance Association, the Academy of Financial Services, and the Midwest Finance Asso-
ciation. He is or has been on the board of directors of the First Interstate Bank of Wisconsin,
Norwest Bank of Indiana, the Investment Analysts Society of Chicago, UBS Global Funds (chair-
man), Fort Dearborn Income Securities (chairman), Discover Bank, NIBCO, Inc., the Interna-
tional Board of Certified Financial Planners, Battery Park High Yield Bond Fund, Inc., Morgan
Stanley Trust FSB, the CFA Institute Research Foundation (chairman), the Financial Analysts
Seminar, the Board of Certified Safety Professionals, and the University Club at the University
of Notre Dame.
As the author of more than 100 articles, monographs, and papers, his work has appeared in
numerous publications including Journal of Finance, Journal of Financial and Quantitative Anal-
ysis, Journal of Accounting Research, Financial Management, Financial Analysts Journal, Journal
of Fixed Income, and Journal of Portfolio Management. In addition to Investment Analysis and
Portfolio Management, 10th ed., Professor Reilly is the coauthor of another textbook, Invest-
ments, 7th ed. (South-Western, 2006) with Edgar A. Norton. He is editor of Readings and Issues
in Investments, Ethics and the Investment Industry, and High Yield Bonds: Analysis and Risk
Assessment.
Professor Reilly was named on the list of Outstanding Educators in America and has received
the University of Illinois Alumni Association Graduate Teaching Award, the Outstanding Educa-
tor Award from the MBA class at the University of Illinois, and the Outstanding Teacher Award
from the MBA class and the senior class at Notre Dame. He also received from the CFA Insti-
tute both the C. Stewart Sheppard Award for his contribution to the educational mission of the
Association and the Daniel J. Forrestal III Leadership Award for Professional Ethics and Stan-
dards of Investment Practice. He also received the Hortense Friedman Award for Excellence
from the CFA Society of Chicago and a Lifetime Achievement Award from the Midwest Finance
Association. He was part of the inaugural group selected as a fellow of the Financial Manage-
ment Association International. He is or has been a member of the editorial boards of Financial
Management, The Financial Review, International Review of Economics and Finance, Journal of
Financial Education, Quarterly Review of Economics and Finance, and the European Journal of
Finance. He is included in Who’s Who in Finance and Industry, Who’s Who in America, Who’s
Who in American Education, and Who’s Who in the World.

xxi
xxii About the Authors

Keith C. Brown holds the position of University Distinguished Teaching Professor of Finance
and Fayez Sarofim Fellow at the McCombs School of Business, University of Texas. He received
a BA in economics from San Diego State University, where he was a member of the Phi Beta
Kappa, Phi Kappa Phi, and Omicron Delta Epsilon honor societies. He received his MS and
PhD in financial economics from the Krannert Graduate School of Management at Purdue Uni-
versity. Since leaving school in 1981, he has specialized in teaching investment management,
portfolio management and security analysis, capital markets, and derivatives courses at the
undergraduate, MBA, and PhD levels, and he has received numerous awards for teaching inno-
vation and excellence, including election to the university’s prestigious Academy of Distin-
guished Teachers. In addition to his academic responsibilities, he has also served as president
and chief executive officer of The MBA Investment Fund, LLC, a privately funded investment
company managed by graduate students at the University of Texas.
Professor Brown has published more than 45 articles, monographs, chapters, and papers on
topics ranging from asset pricing and investment strategy to financial risk management. His
publications have appeared in such journals as Journal of Finance, Journal of Financial Econom-
ics, Review of Financial Studies, Journal of Financial and Quantitative Analysis, Review of Eco-
nomics and Statistics, Journal of Financial Markets, Financial Analysts Journal, Financial
Management, Journal of Investment Management, Advances in Futures and Options Research,
Journal of Fixed Income, Journal of Retirement, Journal of Applied Corporate Finance, and Jour-
nal of Portfolio Management. In addition to coauthoring Investment Analysis and Portfolio Man-
agement, 11th edition, he is a coauthor of Interest Rate and Currency Swaps: A Tutorial, a
textbook published through the CFA Institute. He received a Graham and Dodd Award from
the Financial Analysts Federation as an author of one of the best articles published by Financial
Analysts Journal in 1990, a Smith-Breeden Prize from the Journal of Finance in 1996, and
a Harry M. Markowitz Special Distinction Award from Journal of Investment Management
in 2016.
In August 1988, Professor Brown received the Chartered Financial Analyst designation from
the CFA Institute, and he has served as a member of that organization’s CFA Candidate Curric-
ulum Committee and Education Committee and on the CFA Examination Grading staff. For
five years, he was the research director of the Research Foundation of the CFA Institute, from
which position he guided the development of the research portion of the organization’s world-
wide educational mission. For several years, he was also associate editor for Financial Analysts
Journal, and he currently holds that position for Journal of Investment Management and Journal
of Behavioral Finance. In other professional service, Professor Brown has been a regional director
for the Financial Management Association and has served as the applied research track chairman
for that organization’s annual conference.
Professor Brown is the cofounder and senior partner of Fulcrum Financial Group, a portfolio
management and investment advisory firm located in Austin, Texas, that currently oversees
three fixed-income security portfolios. From May 1987 to August 1988, he was based in
New York as a senior consultant to the Corporate Professional Development Department at
Manufacturers Hanover Trust Company. He has lectured extensively throughout the world on
investment and risk management topics in the executive development programs for such compa-
nies as Fidelity Investments, JP Morgan Chase, Commonfund, BMO Nesbitt Burns, Merrill
Lynch, Chase Manhattan Bank, Chemical Bank, Lehman Brothers, Union Bank of Switzerland,
Shearson, Chase Bank of Texas, The Beacon Group, Motorola, and Halliburton. He is an advisor
to the boards of the Teachers Retirement System of Texas and the University of Texas Invest-
ment Management Company and has served on the Investment Committee of LBJ Family
Wealth Advisors, Ltd.

Sanford J. Leeds is a distinguished senior lecturer at the McCombs School of Business, Uni-
versity of Texas. He graduated summa cum laude from the University of Alabama with a BS in
 About the Authors xxiii

investment analysis. He has an MBA from The University of Texas Graduate School of Business,
where he received the Dean’s Award for Academic Excellence. He also has a JD from the Uni-
versity of Virginia, where he was on the editorial board of The Virginia Tax Review.
Professor Leeds has been a member of the McCombs faculty for 16 years. For 13 of those
years, Professor Leeds also served as president of The MBA Investment Fund, LLC, a privately
funded investment company managed by graduate students at the McCombs School. During his
time on the faculty, he has taught a wide variety of classes, including Investment Theory and
Practice, Portfolio Management, Capital Markets, Macroeconomics, Corporate Finance, and
Advanced Corporate Finance. He has received numerous teaching awards, including three school
wide awards: the Joe D. Beasley Teaching Award (for teaching in the graduate program), the
CBA Foundation Advisory Council Award for Teaching Innovation, and the Jim Nolen Award
for Excellence in Graduate Teaching. He has received recognition from his students with the
“Outstanding MBA Professor Award” (selected by the full-time MBA students in multiple
years, the Evening MBA students, and the Dallas MBA students) and the “Outstanding MSF
Professor Award” (in multiple years). In 2015, he was selected (at the university level) to be a
Provost Teaching Fellow and then served on the steering committee of that organization. He
currently serves as a Senior Provost Fellow.
Professor Leeds received the Chartered Financial Analyst designation in 1998. He has served
the CFA Institute as a grader, as a member of the Candidate Curriculum Committee, and as an
editor of a candidate reading section. He is also a member of the Texas State Bar.
Prior to joining the faculty, Professor Leeds worked as an attorney and then as a money man-
ager. After starting his career at a large law firm, he left to become a prosecutor. Then he
attended business school and was one of four managers at a firm that had $1.6 billion under
management. In recent years, he has served on the investment committee of the Austin Com-
munity Foundation (a $100 million endowment) and has also been the vice-chair of The Girls’
School of Austin. He is frequently a speaker at industry conferences, normally discussing the
economy and the markets.
PART 1
The Investment Background

Chapter 1
The Investment Setting

Chapter 2
Asset Allocation and Security Selection

Chapter 3
Organization and Functioning of Securities Markets

Chapter 4
Security Market Indexes and Index Funds

1
2

The chapters in this section will provide a background for your study of investments by
answering the following questions:
Why do people invest?
How do you measure the returns and risks for alternative investments?
What factors should you consider when you make asset allocation decisions?
What investments are available?
How do securities markets function?
How and why are securities markets in the United States and around the world changing?
What are the major uses of security market indexes?
How can you evaluate the market behavior of common stocks and bonds?
What factors cause differences among stock and bond market indexes?
In the first chapter, we consider why an individual would invest, how to measure the rates of
return and risk for alternative investments, and what factors determine an investor’s required
rate of return on an investment. The latter point will be important when we work to under-
stand investor behavior, the markets for alternative securities, and the valuation of various
investments.
Because the ultimate decision facing an investor is the makeup of his or her portfolio,
Chapter 2 deals with the all-important asset allocation decision. As we will see, to minimize
risk, investment theory asserts the need to diversify, which leads to a discussion of the specific
steps in the portfolio management process and factors that influence the makeup of an inves-
tor’s portfolio over his or her life cycle. We also begin our exploration of investments available
for investors to select by making an overpowering case for investing globally rather than limit-
ing choices to only U.S. securities. Building on this premise, we discuss several global invest-
ment instruments used in global markets. We conclude the chapter with a review of the
historical returns and measures of risk for a number of different asset class groups.
In Chapter 3, we examine how markets work in general and then specifically focus on the
purpose and function of primary and secondary bond and stock markets. During the past two
decades, significant changes have occurred in the operation of the securities market, including
a trend toward a global capital market, electronic trading markets, and substantial worldwide
consolidation. After discussing these changes and the rapid development of new capital mar-
kets around the world, we speculate about how global markets will continue to consolidate and
will increase available investment alternatives.
Investors, market analysts, and financial theorists generally gauge the behavior of securities
markets by evaluating the return and risk implied by various market indexes and evaluate
portfolio performance by comparing a portfolio’s results to an appropriate benchmark.
Because these indexes are used to make asset allocation decisions and then to evaluate portfo-
lio performance, it is important to have a deep understanding of how they are constructed and
the numerous alternatives available. Therefore, in Chapter 4, we examine and compare a num-
ber of stock market and bond market indexes available for the domestic and global markets.
This initial section provides the framework for you to understand various securities, how to
allocate among alternative asset classes, the markets where these securities are bought and sold,
the indexes that reflect their performance, and how you might manage a collection of invest-
ments in a portfolio using index funds, which are an investable form of the security index.
 CHAPTER 1
The Investment Setting

After you read this chapter, you should be able to answer the following questions:
Why do individuals invest?
What is an investment?
How do investors measure the rate of return on an investment?
How do investors measure the risk related to alternative investments?
What factors contribute to the rates of return that investors require on alternative investments?
What macroeconomic and microeconomic factors contribute to changes in the required rates of return for
investments?
This initial chapter discusses several topics that are basic to the subsequent chapters.
We begin by defining the term investment and discussing the returns and risks related
to investments. This leads to a presentation of how to measure the expected and his-
torical rates of returns for an individual asset or a portfolio of assets. In addition, we
consider how to measure risk not only for an individual investment but also for an
investment that is part of a portfolio.
The third section of the chapter discusses the factors that determine the required
rate of return for an individual investment. The factors discussed are those that con-
tribute to an asset’s total risk. Because most investors have a portfolio of investments,
it is necessary to consider how to measure the risk of an asset when it is a part of a
large portfolio of assets. The risk that prevails when an asset is part of a diversified
portfolio is referred to as its systematic risk.
The final section deals with what causes changes in an asset’s required rate of return
over time. Notably, changes occur because of both macroeconomic events that affect
all investment assets and microeconomic events that affect only the specific asset.

1.1 WHAT IS AN INVESTMENT?

For most of your life, you will be earning and spending money. Rarely, though, will your cur-
rent money income exactly balance with your consumption desires. Sometimes, you may have
more money than you want to spend; at other times, you may want to purchase more than
you can afford based on your current income. These imbalances will lead you either to borrow
or to save to maximize the long-run benefits from your income.
When current income exceeds current consumption desires, people tend to save the excess,
and they can do any of several things with these savings. One possibility is to put the money
under a mattress or bury it in the backyard until some future time when consumption desires
3
4 Part 1: The Investment Background

exceed current income. When they retrieve their savings from the mattress or backyard, they
have the same amount they saved.
Another possibility is that they can give up the immediate possession of these savings for a
future larger amount of money that will be available for future consumption. This trade-off of
present consumption for a higher level of future consumption is the reason for saving. What
you do with the savings to make them increase over time is investment.1
Those who give up immediate possession of savings (that is, defer consumption) expect to
receive in the future a greater amount than they gave up. Conversely, those who consume
more than their current income (that is, borrow) must be willing to pay back in the future
more than they borrowed.
The rate of exchange between future consumption (future dollars) and current consumption
(current dollars) is the pure rate of interest. Both people’s willingness to pay this difference for
borrowed funds and their desire to receive a surplus on their savings (that is, some rate of
return) give rise to an interest rate referred to as the pure time value of money. This interest
rate is established in the capital market by a comparison of the supply of excess income avail-
able (savings) to be invested and the demand for excess consumption (borrowing) at a given
time. If you can exchange $100 of certain income today for $104 of certain income one year
from today, then the pure rate of exchange on a risk-free investment (that is, the time value of
money) is said to be 4 percent (104/100 1).
The investor who gives up $100 today expects to consume $104 of goods and services in the
future. This assumes that the general price level in the economy stays the same. This price sta-
bility has rarely been the case during the past several decades, when inflation rates have varied
from 1.1 percent in 1986 to as much as 13.3 percent in 1979, with a geometric average of
4.2 percent a year from 1970 to 2016. If investors expect a change in prices, they will require a
higher rate of return to compensate for it. For example, if an investor expects a rise in prices
(that is, he or she expects inflation) at an annual rate of 2 percent during the period of invest-
ment, he or she will increase the required interest rate by 2 percent. In our example, the investor
would require $106 in the future to defer the $100 of consumption during an inflationary period
(that is, a 6 percent nominal, risk-free interest rate will be required instead of 4 percent).
Further, if the future payment from the investment is not certain (the borrower may not be
able to pay off the loan when it is due), the investor will demand an interest rate that exceeds
the nominal risk-free interest rate. The uncertainty of the payments from an investment is the
investment risk. The additional return added to the nominal, risk-free interest rate is called a
risk premium. In our previous example, the investor would require more than $106 one year
from today to compensate for the uncertainty. As an example, if the required amount were
$110, $4 (4 percent) would be considered a risk premium.

1.1.1 Investment Defined

From our discussion, we can specify a formal definition of investment. Specifically, an invest-
ment is the current commitment of dollars for a period of time in order to derive future pay-
ments that will compensate the investor for (1) the time the funds are committed, (2) the
expected rate of inflation during this time period, and (3) the uncertainty of the future pay-
ments. The “investor” can be an individual, a government, a pension fund, or a corporation.
Similarly, this definition includes all types of investments, including investments by corpora-
tions in plant and equipment and investments by individuals in stocks, bonds, commodities,
or real estate. This text emphasizes investments by individual investors. In all cases, the inves-
tor is trading a known dollar amount today for some expected future stream of payments that
will be greater than the current dollar amount today.
1
In contrast, when current income is less than current consumption desires, people borrow to make up the difference.
Although we will discuss borrowing on several occasions, the major emphasis of this text is how to invest savings.
 Chapter 1: The Investment Setting 5

At this point, we have answered the questions about why people invest and what they want
from their investments. They invest to earn a return from savings due to their deferred con-
sumption. They want a rate of return that compensates them for the time period of the invest-
ment, the expected rate of inflation, and the uncertainty of the future cash flows. This return,
the investor’s required rate of return, is discussed throughout this book. A central question of
this book is how investors select investments that will give them their required rates of return.
The next section describes how to measure the expected or historical rate of return on an
investment and also how to quantify the uncertainty (risk) of expected returns. You need to
understand these techniques for measuring the rate of return and the uncertainty of these
returns to evaluate the suitability of a particular investment. Although our emphasis will be
on financial assets, such as bonds and stocks, we will refer to other assets, such as art and
antiques. Chapter 2 discusses the range of financial assets and also considers some nonfinan-
cial assets.

1.2 MEASURES OF RETURN AND RISK

The purpose of this book is to help you understand how to choose among alternative invest-
ment assets. This selection process requires that you estimate and evaluate the expected risk–
return trade-offs for the alternative investments available. Therefore, you must understand
how to measure the rate of return and the risk involved in an investment accurately. To meet
this need, in this section we examine ways to quantify return and risk. The presentation will
consider how to measure both historical and expected rates of return and risk.
We consider historical measures of return and risk because this book and other publica-
tions provide numerous examples of historical average rates of return and risk measures for
various assets, and understanding these presentations is important. In addition, these historical
results are often used by investors to estimate the expected rates of return and risk for an asset
class.
The first measure is the historical rate of return on an individual investment over the time
period the investment is held (that is, its holding period). Next, we consider how to measure
the average historical rate of return for an individual investment over a number of time peri-
ods. The third subsection considers the average rate of return for a portfolio of investments.
Given the measures of historical rates of return, we will present the traditional measures of
risk for a historical time series of returns (that is, the variance and standard deviation of the
returns over the time period examined).
Following the presentation of measures of historical rates of return and risk, we turn to esti-
mating the expected rate of return for an investment. Obviously, such an estimate contains a
great deal of uncertainty, and we present measures of this uncertainty or risk.

1.2.1 Measures of Historical Rates of Return

When you are evaluating alternative investments for inclusion in your portfolio, you will often
be comparing investments with widely different prices or lives. As an example, you might want
to compare a $10 stock that pays no dividends to a stock selling for $150 that pays dividends
of $5 a year. To properly evaluate these two investments, you must accurately compare their
historical rates of returns. A proper measurement of the rates of return is the purpose of this
section.
When we invest, we defer current consumption in order to add to our wealth so that we
can consume more in the future. Therefore, when we talk about a return on an investment,
we are concerned with the change in wealth resulting from this investment. This change in
wealth can be either due to cash inflows, such as interest or dividends, or caused by a change
in the price of the asset (positive or negative).
6 Part 1: The Investment Background

If you commit $200 to an investment at the beginning of the year and you get back $220 at
the end of the year, what is your return for the period? The period during which you own an
investment is called its holding period, and the return for that period is the holding period
return (HPR). In this example, the HPR is 1.10, calculated as follows:
Ending Value of Investment
HPR
Beginning Value of Investment
1.1
$220
1 10
$200
This HPR value will always be zero or greater—that is, it can never be a negative value.
A value greater than 1.0 reflects an increase in your wealth, which means that you received a
positive rate of return during the period. A value less than 1.0 means that you suffered a
decline in wealth, which indicates that you had a negative return during the period. An HPR
of zero indicates that you lost all your money (wealth) invested in this asset.
Although HPR helps us express the change in value of an investment, investors generally
evaluate returns in percentage terms on an annual basis. This conversion to annual percentage
rates makes it easier to directly compare alternative investments that have markedly different
characteristics. The first step in converting an HPR to an annual percentage rate is to derive a
percentage return, referred to as the holding period yield (HPY). The HPY is equal to the
HPR minus 1.
1.2 HPY HPR 1
In our example:
HPY 1 10 1 0 10
10%
To derive an annual HPY, you compute an annual HPR and subtract 1. Annual HPR is
found by:
n
1.3 Annual HPR HPR1
where:
n number of years the investment is held
Consider an investment that cost $250 and is worth $350 after being held for two years:
Ending Value of Investment $350
HPR
Beginning Value of Investment $250
1 40
n
Annual HPR 1 401
1 401 2

1 1832
Annual HPY 1 1832 1 0 1832
18 32%
If you experience a decline in your wealth value, the computation is as follows:
Ending Value $400
HPR 0 80
Beginning Value $500
HPY 0 80 1 00 0 20 20%
 Chapter 1: The Investment Setting 7

A multiple-year loss over two years would be computed as follows:

Ending Value $750
HPR 0 75
Beginning Value $1,000
1 n
Annual HPY 0 75 0 751 2

0 866
Annual HPY 0 866 1 00 0 134 13 4%
In contrast, consider an investment of $100 held for only six months that earned a return
of $12:
$112
HPR 1 12 (n 0 5)
100
Annual HPR 1 121 5

1 122
1 2544
Annual HPY 1 2544 1 0 2544
25 44%
Note that we made some implicit assumptions when converting the six-month HPY to an
annual basis. This annualized holding period yield computation assumes a constant annual
yield for each year. In the two-year investment, we assumed an 18.32 percent rate of return
each year, compounded. In the partial year HPR that was annualized, we assumed that the
return is compounded for the whole year. That is, we assumed that the rate of return earned
during the first half of the year is likewise earned on the value at the end of the first six
months. The 12 percent rate of return for the initial six months compounds to 25.44 percent
for the full year.2 Because of the uncertainty of being able to earn the same return in the future
six months, institutions will typically not compound partial year results.
Remember one final point: The ending value of the investment can be the result of a posi-
tive or negative change in price for the investment alone (for example, a stock going from $20
a share to $22 a share), income from the investment alone, or a combination of price change
and income. Ending value includes the value of everything related to the investment.

1.2.2 Computing Mean Historical Returns

Now that we have calculated the HPY for a single investment for a single year, we want to
consider mean rates of return for a single investment and for a portfolio of investments.
Over a number of years, a single investment will likely give high rates of return during some
years and low rates of return, or possibly negative rates of return, during others. Your analysis
should consider each of these returns, but you also want a summary figure that indicates this
investment’s typical experience, or the rate of return you might expect to receive if you owned
this investment over an extended period of time. You can derive such a summary figure by com-
puting the mean annual rate of return (its HPY) for this investment over some period of time.
Alternatively, you might want to evaluate a portfolio of investments that might include sim-
ilar investments (for example, all stocks or all bonds) or a combination of investments (for
example, stocks, bonds, and real estate). In this instance, you would calculate the mean rate
of return for this portfolio of investments for an individual year or for a number of years.

2
To check that you understand the calculations, determine the annual HPY for a three-year HPR of 1.50. (Answer:
14.47 percent.) Compute the annual HPY for a three-month HPR of 1.06. (Answer: 26.25 percent.)
8 Part 1: The Investment Background

Single Investment Given a set of annual rates of return (HPYs) for an individual invest-
ment, there are two summary measures of return performance. The first is the arithmetic
mean return, the second is the geometric mean return. To find the arithmetic mean (AM),
the sum (Σ) of annual HPYs is divided by the number of years (n) as follows:
1.4 AM ΣHPY n
where:
ΣHPY sum of annual holding period yields
An alternative computation, the geometric mean (GM), is the nth root of the product of the
HPRs for n years minus one.
n
1.5 GM πHPR 1 1
where:
π product of the annual holding period returns as follows:
(HPR1 ) (HPR2 ) (HPRn )
To illustrate these alternatives, consider an investment with the following data:
Year Beginning Value Ending Value HPR HPY

1 100.0 115.0 1.15 0.15

2 115.0 138.0 1.20 0.20
3 138.0 110.4 0.80 0.20

AM (0 15) (0 20) ( 0 20) 3

0 15 3
0 05 5%
GM (1 15) (1 20) (0 80) 1 3
1
1 3
(1 104) 1
1 03353 1
0 03353 3 353%
Investors are typically concerned with long-term performance when comparing alternative
investments. GM is considered a superior measure of the long-term mean rate of return because
it indicates the compound annual rate of return based on the ending value of the investment ver-
sus its beginning value.3 Specifically, using the prior example, if we compounded 3.353 percent
for three years, (1.03353)3, we would get an ending wealth value of 1.104.
Although the arithmetic average provides a good indication of the expected rate of return
for an investment during a future individual year, it is biased upward if you are attempting
to measure an asset’s long-term performance. This is obvious for a volatile security. Consider,
for example, a security that increases in price from $50 to $100 during year 1 and drops back
to $50 during year 2. The annual HPYs would be:
Year Beginning Value Ending Value HPR HPY

1 50 100 2.00 1.00

2 100 50 0.50 0.50
3
Note that the GM is the same whether you compute the geometric mean of the individual annual holding period
yields or the annual HPY for a three-year period, comparing the ending value to the beginning value, as discussed
earlier under annual HPY for a multiperiod case.
 Chapter 1: The Investment Setting 9

This would give an AM rate of return of:

(1 00) ( 0 50) 2 50 2
0 25 25%
This investment brought no change in wealth and therefore no return, yet the AM rate of
return is computed to be 25 percent.
The GM rate of return would be:

(2 00 0 50)1 2
1 (1 00)1 2 1
1 00 1 0%
This answer of a 0 percent rate of return accurately measures the fact that there was no change
in wealth from this investment over the two-year period.
When rates of return are the same for all years, the GM will be equal to the AM. If the
rates of return vary over the years, the GM will always be lower than the AM. The difference
between the two mean values will depend on the year-to-year changes in the rates of return.
Larger annual changes in the rates of return—that is, more volatility—will result in a greater
difference between the alternative mean values. We will point out examples of this in subse-
quent chapters.
An awareness of both methods of computing mean rates of return is important because
most published accounts of long-run investment performance or descriptions of financial
research will use both the AM and the GM as measures of average historical returns. We will
also use both throughout this book with the understanding that the AM is best used as an
expected value for an individual year, while the GM is the best measure of long-term perfor-
mance since it measures the compound annual rate of return for the asset being measured.

A Portfolio of Investments The mean historical rate of return (HPY) for a portfolio of
investments is measured as the weighted average of the HPYs for the individual investments
in the portfolio, or the overall percent change in value of the original portfolio. The weights
used in computing the averages are the relative beginning market values for each investment;
this is referred to as dollar-weighted or value-weighted mean rate of return. This technique is
demonstrated by the examples in Exhibit 1.1. As shown, the HPY is the same (9.5 percent)
whether you compute the weighted average return using the beginning market value weights
or if you compute the overall percent change in the total value of the portfolio.
Although the analysis of historical performance is useful, selecting investments for your
portfolio requires you to predict the rates of return you expect to prevail. The next section

E x h ib it 1 .1 Computation of Holding Period Yield for a Portfolio

Number of Beginning Beginning Ending Ending Market Market Weighted

Investment Shares Price Market Value Price Value HPR HPY Weighta HPY
A 100,000 $10 $1,000,000 $12 $1,200,000 1.20 20% 0.05 0.01
B 200,000 20 4,000,000 21 4,200,000 1.05 5 0.20 0.01
C 500,000 30 15,000,000 33 16,500,000 1.10 10 0.75 0.075
Total $20,000,000 $21,900,000 0.095
21,900,000
HPR 1 095
20,000,000
HPY 1 095 1 0 095
9 5%

a
Weights are based on beginning values.
10 Part 1: The Investment Background

discusses how you would derive such estimates of expected rates of return. We recognize the
great uncertainty regarding these future expectations, and we will discuss how one measures
this uncertainty, which is referred to as the risk of an investment.

1.2.3 Calculating Expected Rates of Return

Risk is the uncertainty that an investment will earn its expected rate of return. In the examples
in the prior section, we examined realized historical rates of return. In contrast, an investor
who is evaluating a future investment alternative expects or anticipates a certain rate of return.
The investor might say that he or she expects the investment will provide a rate of return of
10 percent, but this is actually the investor’s most likely estimate, also referred to as a point
estimate. Pressed further, the investor would probably acknowledge the uncertainty of this
point estimate return and admit the possibility that, under certain conditions, the annual rate
of return on this investment might go as low as 10 percent or as high as 25 percent. The
point is, the specification of a larger range of possible returns from an investment reflects the
investor’s uncertainty regarding what the actual return will be. Therefore, a larger range of
possible returns implies that the investment is riskier.
An investor determines how certain the expected rate of return on an investment is by ana-
lyzing estimates of possible returns. To do this, the investor assigns probability values to all
possible returns. These probability values range from zero, which means no chance of the
return, to one, which indicates complete certainty that the investment will provide the speci-
fied rate of return. These probabilities are typically subjective estimates based on the historical
performance of the investment or similar investments modified by the investor’s expectations
for the future. As an example, an investor may know that about 30 percent of the time the rate
of return on this particular investment was 10 percent. Using this information along with
future expectations regarding the economy, one can derive an estimate of what might happen
in the future.
The expected return from an investment is defined as:
n
Expected Return (Probability of Return) (Possible Return)
i 1

1.6 E(Ri ) (P1 )(R1 ) (P2 )(R2 ) (P3 )(R3 ) (Pn Rn )

n
E(Ri ) (Pi )(Ri )
i 1

Let us begin our analysis of the effect of risk with an example of perfect certainty wherein the
investor is absolutely certain of a return of 5 percent. Exhibit 1.2 illustrates this situation.
Perfect certainty allows only one possible return, and the probability of receiving that return
is 1.0. Few investments provide certain returns and would be considered risk-free investments.
In the case of perfect certainty, there is only one value for Pi Ri :
E(Ri ) (1 0)(0 05) 0 05 5%
In an alternative scenario, suppose an investor believed an investment could provide several
different rates of return depending on different possible economic conditions. As an example,
in a strong economic environment with high corporate profits and little or no inflation, the
investor might expect the rate of return on common stocks during the next year to reach as
high as 20 percent. In contrast, if there is an economic decline with a higher-than-average
rate of inflation, the investor might expect the rate of return on common stocks during the
next year to be 20 percent. Finally, with no major change in the economic environment,
the rate of return during the next year would probably approach the long-run average of
10 percent.
 Chapter 1: The Investment Setting 11

E xh ib it 1 .2 Probability Distribution for Risk-Free Investment

Probability
1.00

0.75

0.50

0.25

0
–.05 0.0 0.05 0.10 0.15
Rate of Return

The investor might estimate probabilities for each of these economic scenarios based on
past experience and the current outlook as follows:
Economic Conditions Probability Rate of Return

Strong economy, no inflation 0.15 0.20

Weak economy, above-average inflation 0.15 0.20
No major change in economy 0.70 0.10
This set of potential outcomes can be visualized as shown in Exhibit 1.3.
The computation of the expected rate of return E(Ri ) is as follows:
E(Ri ) (0 15)(0 20) (0 15)( 0 20) (0 70)(0 10)
0 07

E xh ib it 1 .3 Probability Distribution for Risky Investment with Three Possible Rates of Return

Probability
0.80

0.60

0.40

0.20

0
–0.30 –0.20 –0.10 0.0 0.10 0.20 0.30
Rate of Return
12 Part 1: The Investment Background

E xh ib it 1 .4 Probability Distribution for Risky Investment with 10 Possible Rates of Return

Probability
0.15

0.10

0.05

0
–0.40 –0.30 –0.20 –0.10 0.0 0.10 0.20 0.30 0.40 0.50
Rate of Return

Obviously, the investor is less certain about the expected return from this investment than
about the return from the prior investment with its single possible return.
A third example is an investment with 10 possible outcomes ranging from 40 percent to
50 percent with the same probability for each rate of return. A graph of this set of expectations
would appear as shown in Exhibit 1.4.
In this case, there are numerous outcomes from a wide range of possibilities. The expected
rate of return E(Ri ) for this investment would be:

E(Ri ) (0 10)( 0 40) (0 10)( 0 30) (0 10)( 0 20) (0 10)( 0 10) (0 10)(0 0)
(0 10)(0 10) (0 10)(0 20) (0 10)(0 30) (0 10)(0 40) (0 10)(0 50)
( 0 04) ( 0 03) ( 0 02) ( 0 01) (0 00) (0 01) (0 02) (0 03)
(0 04) (0 05)
0 05
The expected rate of return for this investment is the same as the certain return discussed in
the first example; but, in this case, the investor is highly uncertain about the actual rate of
return. This would be considered a risky investment because of that uncertainty. We would
anticipate that an investor faced with the choice between this risky investment and the certain
(risk-free) case would select the certain alternative. This expectation is based on the belief that
most investors are risk averse, which means that if everything else is the same, they will select
the investment that offers greater certainty (that is, less risk).

1.2.4 Measuring the Risk of Expected Rates of Return

We have shown that we can calculate the expected rate of return and evaluate the uncer-
tainty, or risk, of an investment by identifying the range of possible returns from that
investment and assigning each possible return a weight based on the probability that it will
occur. Although the graphs help us visualize the dispersion of possible returns, most inves-
tors want to quantify this dispersion using statistical techniques. These statistical measures
allow you to compare the return and risk measures for alternative investments directly.
Two possible measures of risk (uncertainty) have received support in theoretical work on
portfolio theory: the variance and the standard deviation of the estimated distribution of
expected returns.
 Chapter 1: The Investment Setting 13

In this section, we demonstrate how variance and standard deviation measure the disper-
sion of possible rates of return around the expected rate of return. We will work with the
examples discussed earlier. The formula for variance is as follows:
n 2
Possible Expected
Variance (σ 2 ) (Probability)
i 1
Return Return
1.7
n
(Pi ) Ri E(Ri ) 2
i 1

Variance The larger the variance for an expected rate of return, the greater the dispersion of
expected returns and the greater the uncertainty, or risk, of the investment. The variance for
the perfect-certainty (risk-free) example would be:
n
(σ 2 ) Pi Ri E(Ri ) 2
i 1

1 0 (0 05 0 05)2 1 0(0 0) 0
Note that, in perfect certainty, there is no variance of return because there is no deviation
from expectations and, therefore, no risk or uncertainty. The variance for the second example
would be:
n
(σ 2 ) Pi Ri E(Ri ) 2
i 1

(0 15)(0 20 0 07)2 (0 15)( 0 20 0 07)2 (0 70)(0 10 0 07)2

0 010935 0 002535 0 00063
0 0141

Standard Deviation The standard deviation is the square root of the variance:
n
1.8 Standard Deviation Pi Ri E(Ri ) 2
i 1

For the second example, the standard deviation would be:

σ 0 0141
0 11874 11 874%
Therefore, when describing this investment example, you would contend that you expect a
return of 7 percent, but the standard deviation of your expectations is 11.87 percent.

A Relative Measure of Risk In some cases, an unadjusted variance or standard deviation

can be misleading. If conditions for two or more investment alternatives are not similar—that
is, if there are major differences in the expected rates of return—it is necessary to use a mea-
sure of relative variability to indicate risk per unit of expected return. A widely used relative
measure of risk is the coefficient of variation (CV), calculated as follows:
Standard Deviation of Returns
Coefficient of Variation(CV)
Expected Rate of Return
1.9
σi
E(R)
14 Part 1: The Investment Background

The CV for the preceding example would be:

0 11874
CV
0 07000
1 696
This measure of relative variability and risk is used by financial analysts to compare alternative
investments with widely different rates of return and standard deviations of returns. As an
illustration, consider the following two investments:
Investment A Investment B

Expected return 0.07 0.12

Standard deviation 0.05 0.07
Comparing absolute measures of risk, investment B appears to be riskier because it has a stan-
dard deviation of 7 percent versus 5 percent for investment A. In contrast, the CV figures
show that investment B has less relative variability or lower risk per unit of expected return
because it has a substantially higher expected rate of return:
0 05
CVA 0 714
0 07
0 07
CVB 0 583
0 12
1.2.5 Risk Measures for Historical Returns
To measure the risk for a series of historical rates of returns, we use the same measures as for
expected returns (variance and standard deviation) except that we consider the historical hold-
ing period yields (HPYs) as follows:
n
1.10 σ2 HPYi E(HPY) 2 n
i 1

where:
σ2 variance of the series
HPYi holding period yield during period i
E(HPY) expected value of the holding period yield that is equal to the arithmetic mean
(AM) of the series
n number of observations
The standard deviation is the square root of the variance. Both measures indicate how much
the individual HPYs over time deviated from the expected value of the series. An example
computation is contained in the appendix to this chapter. As is shown in subsequent chap-
ters where we present historical rates of return for alternative asset classes, presenting the
standard deviation as a measure of risk (uncertainty) for the series or asset class is fairly
common.

1.3 DETERMINANTS OF REQUIRED RATES OF RETURN

In this section, we continue our discussion of factors that you must consider when selecting
securities for an investment portfolio. You will recall that this selection process involves find-
ing securities that provide a rate of return that compensates you for (1) the time value of
money during the period of investment, (2) the expected rate of inflation during the period,
and (3) the risk involved.
 Chapter 1: The Investment Setting 15

E x h ib it 1 .5 Promised Yields on Alternative Bonds

Type of Bond 2004 2005 2006 2007 2008 2009 2010

U.S. government 3-month Treasury bills 0.14% 3.16% 4.73% 4.48% 1.37% 0.15% 0.14%
U.S. government 10-year bonds 3.22 3.93 4.77 4.94 3.66 3.26 3.22
Aaa corporate bonds 4.94 5.24 5.59 5.56 5.63 5.31 4.94
Baa corporate bonds 6.04 6.06 6.48 6.47 7.44 7.29 6.04

Source: Federal Reserve Bulletin, various issues.

The summation of these three components is called the required rate of return. This is the
minimum rate of return that you should accept from an investment to compensate you for
deferring consumption. Because of the importance of the required rate of return to the total
investment selection process, this section contains a discussion of the three components and
what influences each of them.
The analysis and estimation of the required rate of return are complicated by the behavior
of market rates over time. First, a wide range of rates is available for alternative investments at
any point in time. Second, the rates of return on specific assets change dramatically over time.
Third, the difference between the rates available (that is, the spread) on different assets
changes over time.
The yield data in Exhibit 1.5 for alternative bonds demonstrate these three characteristics.
First, even though all these securities have promised returns based upon bond contracts, the
promised annual yields during any year differ substantially. As an example, during 2009 the
average yields on alternative assets ranged from 0.15 percent on T-bills to 7.29 percent for
Baa corporate bonds. Second, the changes in yields for a specific asset are shown by the
three-month Treasury bill rate that went from 4.48 percent in 2007 to 0.15 percent in 2009.
Third, an example of a change in the difference between yields over time (referred to as a
spread) is shown by the Baa–Aaa spread.4 The yield spread in 2007 was 91 basis points
(6.47–5.56), but the spread in 2009 increased to 198 basis points (7.29–5.31). (A basis point is
0.01 percent.)
Because differences in yields result from the riskiness of each investment, you must include
and understand the risk factors that affect the required rates of return. Because the required
returns on all investments change over time, and because large differences separate individual
investments, you need to be aware of the several components that determine the required rate
of return, starting with the risk-free rate. In this chapter we consider the three components of
the required rate of return and briefly discuss what affects these components. The presentation
in Chapter 8 on valuation theory will discuss the factors that affect these components in
greater detail.

1.3.1 The Real Risk-Free Rate

The real risk-free rate (RRFR) is the basic interest rate, assuming no inflation and no uncer-
tainty about future flows. An investor in an inflation-free economy who knew with certainty
what cash flows he or she would receive at what time would demand the RRFR on an invest-
ment. Earlier, we called this the pure time value of money because the only sacrifice the

4
Bonds are rated by rating agencies based upon the credit risk of the securities, that is, the probability of default. Aaa
is the top rating Moody’s (a prominent rating service) gives to bonds with almost no probability of default. (Only
U.S. Treasury bonds are considered to be of higher quality.) Baa is a lower rating Moody’s gives to bonds of generally
high quality that have some possibility of default under adverse economic conditions.
16 Part 1: The Investment Background

investor made was deferring the use of the money for a period of time. This RRFR of interest
is the price charged for the risk-free exchange between current goods and future goods.
Two factors, one subjective and one objective, influence this exchange price. The subjective
factor is the time preference of individuals for the consumption of income. When individuals
give up $100 of consumption this year, how much consumption do they want a year from now
to compensate for that sacrifice? The strength of the human desire for current consumption
influences the rate of compensation required. Time preferences vary among individuals, and
the market creates a composite rate that includes the preferences of all investors. This compos-
ite rate changes gradually over time because it is influenced by all the investors in the econ-
omy, whose changes in preferences may offset one another.
The objective factor that influences the RRFR is the set of investment opportunities avail-
able in the economy. The investment opportunities available are determined in turn by the
long-run real growth rate of the economy. A rapidly growing economy produces more and bet-
ter opportunities to invest funds and experience positive rates of return. A change in the econ-
omy’s long-run real growth rate causes a change in all investment opportunities and a change
in the required rates of return on all investments. Just as investors supplying capital should
demand a higher rate of return when growth is higher, those looking to borrow funds to invest
should be willing and able to pay a higher rate of return to use the funds for investment
because of the higher growth rate and better opportunities. Thus, a positive relationship exists
between the real growth rate in the economy and the RRFR.

1.3.2 Factors Influencing the Nominal Risk-Free Rate (NRFR)

Earlier, we observed that an investor would be willing to forgo current consumption in order
to increase future consumption at a rate of exchange called the risk-free rate of interest. This
rate of exchange was measured in real terms because we assume that investors want to
increase the consumption of actual goods and services rather than consuming the same
amount that had come to cost more money. Therefore, when we discuss rates of interest, we
need to differentiate between real rates of interest that adjust for changes in the general price
level, as opposed to nominal rates of interest that are stated in money terms. That is, nominal
rates of interest that prevail in the market are determined by real rates of interest, plus factors
that will affect the nominal rate of interest, such as the expected rate of inflation and the mon-
etary environment.
Notably, the variables that determine the RRFR change only gradually because we are con-
cerned with long-run real growth. Therefore, you might expect the required rate on a risk-free
investment to be quite stable over time. As discussed in connection with Exhibit 1.5, rates on
three-month T-bills were not stable over the period from 2004 to 2010. This is demonstrated
with additional observations in Exhibit 1.6, which contains promised yields on T-bills for the
period 1987–2016.
Investors view T-bills as a prime example of a default-free investment because the govern-
ment has unlimited ability to derive income from taxes or to create money from which to pay
interest. Therefore, one could expect that rates on T-bills should change only gradually. In fact,
the data in Exhibit 1.6 show a highly erratic pattern. Specifically, yields increased from 4.64
percent in 1999 to 5.82 percent in 2000 before declining by over 80 percent in three years to
1.01 percent in 2003, followed by an increase to 4.73 percent in 2006, and concluding at 0.20
percent in 2016. Clearly, the nominal rate of interest on a default-free investment is not stable
in the long run or the short run, even though the underlying determinants of the RRFR are
quite stable because two other factors influence the nominal risk-free rate (NRFR): (1) the rel-
ative ease or tightness in the capital markets and (2) the expected rate of inflation.

Conditions in the Capital Market You will recall from prior courses in economics and
finance that the purpose of capital markets is to bring together investors who want to invest
 Chapter 1: The Investment Setting 17

E x h ib it 1 .6 Three-Month Treasury Bill Yields and Rates of Inflation

Year 3-Month T-bills (%) Rate of Inflation (%) Year 3-Month T-bills (%) Rate of Inflation (%)
1987 5.78 4.40 2002 1.61 2.49
1988 6.67 4.40 2003 1.01 1.87
1989 8.11 4.65 2004 1.37 3.26
1990 7.50 6.11 2005 3.16 3.42
1991 5.38 3.06 2006 4.73 2.54
1992 3.43 2.90 2007 4.48 4.08
1993 3.33 2.75 2008 1.37 0.09
1994 4.25 2.67 2009 0.15 2.72
1995 5.49 2.54 2010 0.14 1.50
1996 5.01 3.32 2011 0.04 2.96
1997 5.06 1.70 2012 0.06 1.74
1998 4.78 1.61 2013 0.02 1.51
1999 4.64 2.70 2014 0.02 0.76
2000 5.82 3.40 2015 0.02 0.73
2001 3.40 1.55 2016 0.20 2.07

Source: Federal Reserve Bulletin, various issues; Economic Report of the President, various issues.

savings with companies that need capital to expand or to governments that need to finance
budget deficits. The cost of funds at any time (the interest rate) is the price that equates the
current supply and demand for capital. Beyond this long-run equilibrium, there are short-run
changes in the relative ease or tightness in the capital market caused by temporary disequilib-
rium in the supply and demand of capital.
As an example, disequilibrium could be caused by an unexpected change in monetary pol-
icy (for example, a change in the target federal funds rate) or fiscal policy (for example, a
change in the federal deficit). Such changes will produce a change in the NRFR of interest,
but the change should be short-lived because, in the longer run, the higher or lower interest
rates will affect capital supply and demand. As an example, an increase in the federal deficit
caused by an increase in government spending (easy fiscal policy) will increase the demand
for capital and lead to an increase in interest rates. In turn, this increase in interest rates
should cause an increase in savings and a decrease in the demand for capital by corporations
or individuals. These changes in market conditions should bring rates back to the long-run
equilibrium, which is based on the long-run growth rate of the economy.

Expected Rate of Inflation Previously, it was noted that if investors expect an increase in
the inflation rate during the investment period, they will require the rate of return to include
compensation for the expected rate of inflation. Assume that you require a 4 percent real rate
of return on a risk-free investment, but you expect prices to increase by 3 percent during the
investment period. In this case, you should increase your required rate of return by this
expected rate of inflation to about 7 percent [(1.04 1.03) 1]. If you do not increase your
required return, the $104 you receive at the end of the year will represent a real return of
about 1 percent, not 4 percent. Because prices have increased by 3 percent during the year,
what previously cost $100 now costs $103, so you can consume only about 1 percent more at
the end of the year [($104/$103) 1]. If you had required a 7.12 percent nominal return, your
real consumption could have increased by 4 percent [($107.12/$103) 1]. Therefore, an
investor’s nominal required rate of return on a risk-free investment should be:
1.11 NRFR (1 RRFR) (1 Expected Rate of Inflation) 1
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novelty, and I do not see why Catholics should not keep to it and
leave the outline of history alone. I do not say that it is a line of
apologetics that would convince me altogether, but it is one that
would need far more arduous discussion and merit, far more respect
than Mr. Belloc’s a priori exploits, his limping lizards and flying pigs.
But it is not my business to remind Catholics of their own
neglected philosophers, and clearly the publication of Mr. Belloc’s
articles by the Universe, the Catholic Bulletin, and the Southern
Cross shows that the Catholic world of to-day is stoutly resolved to
treat the fall of man and his unalterable nature as matters of fact,
even if they are rather cloudy matters of fact, and to fight the realities
of modern biology and anthropology to the last ditch.
So the Catholics are pinned to this dogma of the fixity of man
and thereby to a denial of progress. This vale of tears, they maintain,
is as a whole a stagnant lake of tears, and there is no meaning to it
beyond the spiritual adventures of its individual lives. Go back in time
or forward, so long as man has been or will be, it is all the same. You
will find a world generally damned, with a select few, like Mr. Belloc,
on their way to eternal beatitude. That is all there is to the spectacle.
There is, in fact, no outline of history; there is just a flow of individual
lives; there is only birth and salvation or birth and damnation. That, I
extract from Mr. Belloc and other contemporary writers, is the
Catholic’s vision of life.

The Idea of Fixed Humanity

And it is not only the Catholic vision of life. It is a vision far more
widely accepted. I would say that, if we leave out the ideas of
damning or beatitude, it is the “common-sense” vision of the world.
The individual life is, to common-sense, all that matters, the entire
drama. There is from this popular and natural point of view no large,
comprehensive drama in which the individual life is a subordinate
part. Just as to the untutored mind the world is flat, just as to Mr.
Belloc during his biological research work in Sussex the species of
pig remained a “fixed type,” so to the common intelligence life is
nothing more or less than “Me,” an unquestioned and unanalysed
Me, against the universe.
The universe may indeed be imagined as ruled over and
pervaded by God, and this world may be supposed to have
extensions of hell and heaven; all sorts of pre-natal dooms and debts
may affect the career of the Me, but nevertheless the Me remains in
the popular mind, nobbily integral, one and indivisible, and either it
ends and the drama ends with it, or it makes its distinct and special
way to the Pit, or, with Belloc and the Catholic community, to the
beatitude he anticipates.
The individual self is primary to this natural, primitive, and
prevalent mode of thinking. But it is not the only way of thinking
about life. The gist of the Outline of History is to contradict this self-
centred conception of life and show that this absolute individualism
of our thought and destinies is largely illusory. We do not live in
ourselves, as we so readily imagine we do; we are contributory parts
in the progress of a greater being which is life, and which becomes
now conscious of itself through human thought.

The Fundamental Issue

Now here I think we get down, beneath all the frothings and
bespatterings of controversy, to the fundamental difference between
Mr. Belloc and myself. It is this which gives our present controversy
whatever claim it can have to attention. Neither Mr. Belloc nor myself
is a very profound or exhaustive philosopher. In ourselves we are
very unimportant indeed. But we have this in common, that we can
claim to be very honestly expressive of the mental attitudes of clearly
defined types of mind, and that we are sharply antithetical types.
By nature and training and circumstances Mr. Belloc stands for
the stout sensible fellow who believes what he sees; who considers
that his sort always has been and always will be; who stands by
accepted morals and time-honoured ways of eating and drinking and
amusement; who loves—and grips as much as he can of—the good
earth that gives us food for our toil; who begets children honestly by
one beloved wife until she dies and then repeats the same
wholesome process with the next; who believes in immortality lest he
should be sorry to grow old and die; who trusts in the Church and its
teaching because visibly the Church is a great and impressive fact,
close at hand and extremely reassuring; who is a nationalist against
all strangers because, confound it! there are nations, and for
Christendom against all pagans; who finds even Chinamen and
Indians remote and queer and funny. I do not think that is an unfair
picture of the ideals of Mr. Belloc and of his close friend and ally, Mr.
Chesterton, as they have spread them out for us; and I admit they
are warm and rosy ideals. But they are ideals and not realities. The
real human being upon this swift-spinning planet is not that stalwart,
entirely limited, fixed type resolved to keep so, stamping about the
flat world under God’s benevolent sky, eating, drinking, disputing,
and singing lustily, until he passes on to an eternal individual
beatitude with God and all the other blessed ones. He is less like
that every day, and more and more conscious of the discrepancy.
I have read and admired and sympathised with the work of Mr.
Belloc and Mr. Chesterton since its very beginnings, but I find
throughout it all a curious defensive note. It may be I attribute
distresses to them that they do not feel. But it seems to me they are
never quite sure in their minds about this “fixed” human being of
theirs—the same yesterday, now, and for ever. Mr. Belloc must be
puzzled not a little by that vast parade of Evolution through the
immeasurable ages which he admits has occurred—a parade made
by the Creative Force for no conceivable reason, since a “fixed type”
might just as well have been created straight away. He must realise
that if man is the beginning and end of life, then his Creator has
worked within fantastically disproportionate margins both of space
and time. And in his chapters upon animal and human origins Mr.
Belloc’s almost obstinate ignorance of biological facts, his fantastic
“logic,” his pathetic and indubitably honest belief in his non-existent
“European authorities,” his fumbling and evasion about Palæolithic
man, and above all his petty slights and provocations to those whose
views jar upon him, have nothing of the serenity of a man assured of
his convictions, and all the irritability and snatching at any straw of
advantage of a man terribly alarmed for his dearest convictions.
When Mr. Belloc gets to his beatitude he will feel like a fish out of
water. I believe Mr. Belloc and his friend Mr. Chesterton are far too
intelligent not to be subconsciously alive to the immense and
increasing difficulties of their positions, and that they are fighting
most desperately against any conscious realisation of the true state
of affairs.

The Idea of Progressive Humanity

It happens that my circumstances, and perhaps my mental
temperament, have brought my mind into almost dramatic opposition
to that of Mr. Belloc. While his training was mainly in written history,
the core of mine was the analytical exercises of comparative
anatomy and palæontology. I was brought up upon the spectacle of
life in the universe as a steadily changing system. My education was
a modern one, upon material and questionings impossible a hundred
years ago. Things that are fundamental and commonplaces to me
have come, therefore, as belated, hostile, and extremely distressing
challenges to the satisfactions and acceptances of Mr. Belloc.
Now, this picture of a fixed and unprogressive humanity working
out an enormous multitude of individual lives from birth to either
eternal beatitude or to something not beatitude, hell or destruction or
whatever else it may be that Mr. Belloc fails to make clear is the
alternative to beatitude—this picture, which seems to be necessary
to the Catholic and probably to every form of Christian faith, and
which is certainly necessary to the comfort of Mr. Belloc, has no
validity whatever for my mind. It is no more possible in my thought as
a picture of reality than that ancient cosmogony which made the
round earth rest upon an elephant, which stood upon a tortoise,
which stood upon God-knows-what.
 I do not know how the universe originated, or what it is
fundamentally; I do not know how material substance is related to
consciousness and will; I doubt if any creature of my calibre is
capable of knowing such things; but at least I know enough to judge
the elephant story and the fixed humanity story absurd. I do not
know any convincing proof that Progress must go on; I find no
invincible imperative to progressive change in my universe; but I
remark that progressive change does go on, and that it is the form
into which life falls more and more manifestly as our analysis
penetrates and our knowledge increases. I set about collecting what
is known of life and the world in time and space, and I find the broad
outline falls steadily and persistently into a story of life appearing and
increasing in range, power, and co-operative unity of activity. I see
knowledge increasing and human power increasing, I see ever-
increasing possibilities before life, and I see no limits set to it all.
Existence impresses me as a perpetual dawn. Our lives, as I
apprehend them, swim in expectation. This is not an outline I have
thrust upon the facts; it is the outline that came naturally as the facts
were put in order.
And it seems to me that we are waking up to the realisation that
the individual life does not stand alone, as people in the past have
seemed to imagine it did, but that it is far truer to regard it as an
episode in a greater life, which progresses and which need not die.
The episode begins and ends, but life goes on.
Mr. Belloc is so far removed from me mentally that he is unable
to believe that this, clearly and honestly, is how I see things; he is
moved to explain it away by saying that I am trying to “get rid of a
God,” that I am a rotten Protestant, that this is what comes of being
born near London, that if I knew French and respected the Gentry all
this would be different, and so on, as the attentive student of his
great apology for Catholicism has been able to observe. But all the
while he is uncomfortably on the verge of being aware that I am a
mere reporter of a vast mass of gathered knowledge and lengthened
perspectives that towers up behind and above his neat and jolly
marionette show of the unchanging man and his sins and
repentances and mercies, his astonishing punishments, and his
preposterous eternal reward among the small eternities of the
mediæval imagination. I strut to no such personal beatitude. I have
no such eternity of individuation. The life to which I belong uses me
and will pass on beyond me, and I am content.

The New Thought and the Old

Mr. Belloc is completely justified in devoting much more than half
his commentary to these fundamental issues and dealing with my
account of the appearance of Christianity and the story of the Church
much more compactly. It is this difference at the very roots of our
minds which matters to us, and it is the vital question we have to put
before the world. The rest is detail. I do believe and assert that a
new attitude to life, a new and different vision of the world, a new
moral atmosphere and a different spirit of conduct, is coming into
human affairs, as a result of the scientific analysis of the past
hundred years. It is only now reaching such a clearness of definition
that it can be recognised for what it is and pointed out.
The essential distinction of the newer thought in the world is in
its denial of the permanence of the self and in its realisation of the
self’s comparative unimportance. Even in our individual lives we are
increasingly interested in common and generalised things. The older
commoner life, the religious life just as much as the most worldly life,
seems to us excessively self-conscious. The religious life, its
perpetual self-examination for sin and sinful motives, its straining
search after personal perfection, appears in the new light as being
scarcely less egotistical than a dandy’s. And this new way of living
and thinking is directly linked on to the idea of progress, which
makes life in general far more interesting than any individual life can
be, just as the self-centred life, whether it be religious and austere or
vain or self-indulgent, is directly connected with the old delusions of
permanence which rob life in general of any sustained interest.
When one is really persuaded that there is nothing new under the
sun, then there is nothing worth living for whatever outside the
personal adventure, the dance between permanent individual
beatitude or permanent individual damnation.
As this modern conception of life as a process of progressive
change in which individuality of our order can be sometimes
excessively exaggerated as it has been in the past and sometimes
minimised as is happening now—as this conception establishes
itself, it changes the spirit of living and the values of our general
ideas about living profoundly. Lit only by a very bright light held low,
an ordinary road becomes a tangle of vivid surfaces and black
shadows, and you cannot tell a puddle or a gutter from a ditch or a
precipice. But in diffused daylight you can see the proportions of
every irregularity. So too with changing illumination our world alters
its aspects, and things that once seemed monstrous and final are
seen to be mere undulations in a practicable progress. We can
realise now, as no one in the past was ever able to realise it, that
man is a creature changing very rapidly from the life of a rare and
solitary great ape to the life of a social and economic animal. He has
traversed most of this tremendous change of phase in something in
the nature of a million years. His whole being, mind and body alike,
betrays the transition. We can trace the mitigations of his egotism
through the development of religious and customary restraints. The
recent work of the psycho-analyst enables us to understand
something of the intricate system of suppressions and inhibitions that
this adaptation to a more and more complex social life has involved.
We begin to realise how man has symbolised and personified his
difficulties, and to comprehend the mechanisms of his uncongenial
but necessary self-restraint.

Old Wine in New Bottles

The disposition of those who apprehend this outline of history
that modern science has made plain to us, and who see all life as a
system of progressive change, is by no means antagonistic to
religion. They realise the immense importance and the profound
necessity of religion in this last great chapter of the story, the
evolution of human society. But they see religion within the frame of
fact; they do not, like Mr. Belloc, look through religion at fact. Man
has accommodated his originally fierce and narrow egotism to the
needs of an ever wider and more co-operative social life, very largely
through the complex self-subjugations that religion has made
possible. Within the shell and cover of religion the new less self-
centred habits of mind have been able to develop. An immense
mass of imaginative work, of mythology, of theology, that now seems
tortuous, mystical, and fantastic, was necessary for the casting of the
new moral being of socialised man. We seem to be entering upon a
phase in which moral and intellectual education may be able to free
themselves from the last vestiges of the mythology in which that new
moral being was moulded; but it is ungracious and false to the true
outline of history to deny the necessary part that the priest, the
sacrifice, the magic ceremonial for tribal welfare, the early tribal
religions, have played in this transfiguration of the sub-human into
the modern human mind, upon which all our community rests to-day.
It is because of our sense of this continuity of our present
dispositions with the religions upon which they are founded that so
many of us are loth to part with all the forms and phrases of the old
creeds and all the disciplines of time-honoured cults. Perhaps some
of us (the present writer in the crowd among others) have been over-
eager to read new significances into established phrases, and clothe
new ideas in the languages of the old scheme of salvation. It may be
we have been pouring new wine into old bottles. It may be better to
admit frankly that if man is not fixed Christianity is, and that mankind
is now growing out of Christianity; that indeed mankind is growing
out of the idea of Deity. This does not mean an end to religion, but it
means a fresh orientation of the religious life. It means a final
severance with those anthropomorphic conceptions of destiny, that
interpretation of all things in terms of personality and will with which
religion began. For many of us that still means a wrench and an
effort. But the emphatic assertions of Mr. Belloc, the stand that
Catholicism, as he expounds it, makes against any progressive
adaptation to the new spirit in human life, may render that effort
easier.
 In this examination of Mr. Belloc’s opening and more
fundamental attacks upon the Outline of History I have shown
sufficiently that Mr. Belloc is incapable of evidence or discussion,
that he imagines his authorities, that he is careless and ignorant as
to his facts and slovenly and tricky in his logic. I have dealt kindly but
adequately with his atrocious bad manners and his insolence and
impudence. I do not think it is worth while to go on through the
second half of his outpourings with any particularity. It is exactly the
same kind of thing, but upon more familiar ground and less
fundamental issues. Mr. Belloc quibbles. He falsifies. For example,
he imagines traditions to reinforce the Gospel account of Christ’s
teaching and to show that the founder of Christianity was aware of
his godhead and taught the doctrine of the Trinity; he declares—just
out of his head—that I do not know it was the bull and not Mithra
who was sacrificed in the system of Mithraism, though I state that
quite plainly in a passage he has ventured to ignore. And so on. The
wonderful methods of the Palæolithic bow story repeat themselves
with variations, time after time. Why should I trouble to repeat the
exposure in every case? I have done enough to demonstrate the
quality of this effort to bluff and bawl away accepted knowledge and
manifest fact, and that is all that I set out to do.
And this apparently is the present state of Catholic teaching.
This stuff I have examined is the current utterance of organised
Christianity, so far as there is any utterance, upon the doctrines of
the Creation and the Fall—doctrines upon which rest the whole
scheme of Christian salvation and the entire fabric of a Christian’s
faith.
 Transcriber’s Notes
Punctuation, hyphenation, and spelling were made
consistent when a predominant preference was found in the
original book; otherwise they were not changed.
Simple typographical errors were corrected; unbalanced
quotation marks were remedied when the change was
obvious, and otherwise left unbalanced. Several apparent
misspellings may be intentional, and have not been changed.
Illustrations in this eBook have been positioned between
paragraphs and outside quotations.
Page 69: Page 69: “Mr. Belloc will get if he says” probably
is missing an “it” after “get”.
Page 95: Part of the last paragraph was misprinted.
Transcriber has attempted to correct that error. The original
text was:

And this apparently is the present state of

Catholic teaching. This stuff I have examined is
ance of organised Christianity, so far as there is
representative stuff. This is the current utter-
ance of organised Christianity, so far as there is
any utterance, upon the doctrines of the Creation
and the Fall—doctrines upon which rest the whole
scheme of Christian salvation and the entire fabric
of a Christian’s faith.
 *** END OF THE PROJECT GUTENBERG EBOOK MR. BELLOC
OBJECTS TO "THE OUTLINE OF HISTORY" ***

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