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Understanding Historical Returns in Capital Markets: Risk, Reward, and Efficiency Overview

Explore historical returns from 1926-2008, risk and reward balance, market efficiency concepts, implications for investors, and strategies to reduce risk while aiming for returns in capital markets. Learn about different forms of market efficiency and key considerations for intelligent investing.

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Understanding Historical Returns in Capital Markets: Risk, Reward, and Efficiency Overview

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  1. Risk and Return: Historical Perspective • Historical Returns • Market Efficiency Capital Markets

  2. Historical Returns 1926-2008 • Average returns • Arithmetic versus geometric • Risk premium = • Return – risk-free return • Compensation for taking risk • Standard deviation • Measures variability of returns • Two-thirds of the time returns should fall: Capital Markets

  3. Can Stock B have the same Expected Return as Stock A??? Expected Return Capital Markets

  4. Historical Returns 1926-2008 10/15/99 Wall Street Journal, equity risk premium has fallen from 10% in early 1980s to 2% in recent months… Capital Markets

  5. Unusual returns • S&P 500 Annual Return • 1995: 37.6% • 1996: 23.0% • 1997: 33.4% • 1998: 28.6% • 1999: 21.9% Capital Markets

  6. Time In Market Capital Markets

  7. Implications • Correlation of risk and reward • To achieve above average returns, you must take risk • This can be done in an intelligent fashion!!! • Knowing your risk tolerance • Time horizon: how long until I need this money? • Diversification Capital Markets

  8. Time in Market • Investing for long-periods of time, likely you will have positive returns • Investing for long-period of time reduces risk. • Time in market, not timing market is your goal. • In the short-run, anything can happen Capital Markets

  9. Reducing Risk While Obtaining Returns • Diversify • Invest for long-term Capital Markets

  10. Forms of market efficiency • Strong: all information is reflected in stock prices • Including public and private information • No one can outperform the market • What about Martha? • Use of index funds • Diversification • Efficiency • Underperformance by investors • Average return large cap: • Average return large cap mutual fund: • Expenses: management fees/trading costs • Average return large cap mutual fund investor: • Buying last period’s top performer Capital Markets

  11. Forms of market efficiency • Semi-strong: all publicly available information is reflected in stock prices • Corporate financial analysis is a waste of time • Stock prices only react to “new” information differing from expectations • Questions: • Assumes intelligent investors? • Valid assumption? • Decline in inventory turnover ratio??? • Assumes rational investors? • Valid assumption? Capital Markets

  12. Forms of market efficiency • Weak: all prior stock price patterns reflected in stock prices • Technical analysis is a waste of time • Question… • January effect…anomaly?? • Sell losers, deduct losses up to $3,000 • Hold winners, pay not tax until you sell Capital Markets

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