Chapter 12

Lessons From
Capital Market
History
Prepared By
Jason Wong, MBA, CPA, CMA

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 Key Concepts and Skills
• Know how to calculate the return on an
investment
• Understand the historical returns on
various types of investments
• Understand the historical risks on various
types of investments
• Know the implications of market efficiency

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 Chapter Outline
• Returns
• The Historical Record
• Average Returns: The First Lesson
• The Variability of Returns: The Second
Lesson
• More on Average Returns
• Capital Market Efficiency
• Summary and Conclusions
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 Risk, Return and Financial
Markets
• We can examine returns in the financial
markets to help us determine the
appropriate returns on non-financial assets
• Lesson from capital market history
• There is a reward for bearing risk
• The greater the potential reward, the greater the
risk
• This is called the risk-return trade-off

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 Dollar Returns
• Total dollar return = income from investment +
capital gain (loss) due to change in price
• Example:
• You bought a bond for $950 1 year ago. You
have received two coupons of $30 each. You
can sell the bond for $975 today. What is your
total dollar return?
• Income = 30 + 30 = 60
• Capital gain = 975 – 950 = 25
• Total dollar return = 60 + 25 = $85

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 Percentage Returns
• It is generally more intuitive to think in
terms of percentages than dollar returns
• Dividend yield = income / beginning price
• Capital gains yield = (ending price –
beginning price) / beginning price
• Total percentage return = dividend yield +
capital gains yield

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 Example – Calculating Returns
• You bought a stock for $35 and you
received dividends of $1.25. The stock is
now selling for $40.
• What is your dollar return?
• Dollar return = 1.25 + (40 – 35) = $6.25
• What is your percentage return?
• Dividend yield = 1.25 / 35 = 3.57%
• Capital gains yield = (40 – 35) / 35 = 14.29%
• Total percentage return = 3.57 + 14.29 = 17.86%

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 The Importance of Financial
Markets
• Financial markets allow companies, governments
and individuals to increase their utility
• Savers have the ability to invest in financial assets
so that they can defer consumption and earn a
return to compensate them for doing so
• Borrowers have better access to the capital that is
available so that they can invest in productive
assets
• Financial markets also provide us with information
about the returns that are required for various levels
of risk
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Figure 12.4 – If you invested $1 in 1957,
how much would you have in 2014?

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 Table 12.2 Average Returns
1957 – 2014
Arithmetic Average
Investment
Return (%)
Canadian common stocks 10.30
U.S. common stocks (Cdn $) 11.73
Long bonds 8.57
Small stocks 12.81
TSX Venture stocks 7.16
Inflation 3.82
Treasury bills 5.88

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 Risk Premiums
• The “extra” return earned for taking on risk
• Treasury bills are considered to be risk-free
• The risk premium is the return over and
above the risk-free rate

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 Table 12.3 Average Returns and
Risk Premiums 1957 – 2014

Investment Arithmetic Average return (%) Risk Premium (%)

Canadian common stocks 10.30 4.42
U.S. common stocks (Cdn $) 11.73 5.85
Long bonds 8.57 2.69
Small stocks 12.81 6.93
TSX Venture stocks 7.16 1.28
Inflation 3.82 2.06
Treasury bills 5.88 0.00

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 Historical Risk Premiums 1957 – 2008
• Canadian common stocks: 10.30 – 5.88 =
4.42%
• US common stocks (C$): 11.73 – 5.88 =
5.85%
• Long-term bonds: 8.57 – 5.88 = 2.69%
• Small stocks: 12.81 – 5.88 = 6.93%
• TSX Venture Stocks: 7.16 – 5.88 = 1.28%
• Would small stocks be more risky than
bonds?
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Variance and Standard Deviation
• Variance and standard deviation measure
the volatility of asset returns
• The greater the volatility, the greater the
uncertainty
• Historical variance = sum of squared
deviations from the mean / (number of
observations – 1)
• Standard deviation = square root of the
variance
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Example – Variance and Standard
Deviation
Year Actual Average Deviation from the Squared
Return Return Mean Deviation
1 .15 .105 .045 .002025

2 .09 .105 -.015 .000225

3 .06 .105 -.045 .002025

4 .12 .105 .015 .000225

Totals .42 .00 .0045

Variance = .0045 / (4-1) = .0015 Standard Deviation = .03873

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 Table 12.4 Historical Returns and
Standard Deviations 1957 – 2014
Investment Arithmetic Average return (%) Standard Deviation (%)
Canadian common stocks 10.30 16.50
U.S. common stocks (Cdn $) 11.73 16.94
Long bonds 8.57 9.78
Small stocks 12.81 25.96
TSX Venture stocks 7.16 44.35
Inflation 3.82 2.10
Treasury bills 5.88 3.83

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Figure 12.6 – Normal Distribution and a
Portfolio of Large Common Stocks

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Figure 12.5 – Frequency distribution of
Returns on Canadian Common Stocks

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 More on Average Returns
• There are many different ways of
calculating returns over multiple periods
• Two methods are:
• Arithmetic Average Return
• Geometric Average Return

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 Arithmetic vs. Geometric Average Example

• You invested $100 in a stock five years

ago. Over the last five years, annual
returns have been 15%, -8%, 12%, 18%
and -11%. What is your average annual
rate of return? What is your investment
worth today?

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Calculating Arithmetic Average
15  ( 8)  12  18  ( 11)
Arithmetic Average Return  RA 
5

R A  5.2

• The return in an average year was 5.2%.

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What is the investment worth today?

• FV=$100(1+.15)(1-.08)(1+.12)(1+.18)(1-.11)
• FV=$124.44

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 Calculating Geometric Average Continued

• What equivalent rate of return would you have to earn

every year on average to achieve this same future
wealth?
5
$124.44  $100  (1  RG )
1
RG  1.2444 5
1
RG  4.47%
• Your average return was 4.47% each year. Notice that
this is lower than the arithmetic average. This is because
it includes the effects of compounding.
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 Geometric Average
• The general formula for calculating the
geometric average return is the following:

Geometric Average Return  1  R 1  1  R 2  ...  1  R T  T  1

1

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 Geometric vs. Arithmetic Average
Returns 1957-2014
Average Return

Investment Arithmetic (%) Geometric (%) Standard deviation (%)

Canadian common stocks 10.30 9.01 16.50
U.S. common stocks (Cdn $) 11.73 10.42 16.94
Long bonds 8.57 8.16 9.78
Small stocks 12.81 9.83 25.96
TSX Venture stocks 7.16 2.69 44.35
Inflation 3.82 3.77 3.10

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 Capital Market Efficiency
• Stock prices are in equilibrium or are
“fairly” priced
• If this is true, then you should not be able
to earn “abnormal” or “excess” returns
• Efficient markets DO NOT imply that
investors cannot earn a positive return in
the stock market

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Figure 12.7 – Reaction to New Information

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 What Makes Markets Efficient?
• There are many investors out there doing
research
• As new information comes to market, this
information is analyzed and trades are made
based on this information
• Therefore, prices should reflect all available
public information
• If investors stop researching stocks, then
the market will not be efficient

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 Common Misconceptions about
EMH
• Efficient markets do not mean that you can’t
make money
• They do mean that, on average, you will earn a
return that is appropriate for the risk undertaken
and there is not a bias in prices that can be
exploited to earn excess returns
• Market efficiency will not protect you from wrong
choices if you do not diversify – you still don’t
want to put all your eggs in one basket

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 Strong Form Efficiency
• Prices reflect all information, including
public and private
• If the market is strong form efficient, then
investors could not earn abnormal returns
regardless of the information they
possessed
• Empirical evidence indicates that markets
are NOT strong form efficient and that
insiders could earn abnormal returns
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 Semistrong Form Efficiency
• Prices reflect all publicly available
information including trading information,
annual reports, press releases, etc.
• If the market is semistrong form efficient,
then investors cannot earn abnormal
returns by trading on public information
• Implies that fundamental analysis will not
lead to abnormal returns

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 Weak Form Efficiency
• Prices reflect all past market information
such as price and volume
• If the market is weak form efficient, then
investors cannot earn abnormal returns by
trading on market information
• Implies that technical analysis will not lead
to abnormal returns
• Empirical evidence indicates that markets
are generally weak form efficient

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 Quick Quiz
• Which of the investments discussed have
had the highest average return and risk
premium?
• Which of the investments discussed have
had the highest standard deviation?
• What is the difference between an arithmetic
and a geometric average?
• What is capital market efficiency?
• What are the three forms of market
efficiency?
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 Summary
• You should know that:
• Risky assets earn a risk premium
• Greater risk requires a larger required reward
• In an efficient market, prices adjust quickly and
correctly to new information
• The three levels of market efficiency are strong
form efficient, semi strong form efficient, and
weak form efficient.

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