Chapter 12: Lessons from Capital Marketing History Flashcards
Return on your investment definition
If you buy an asset of any sort, your gain (or loss) from that investment
This return usually has two components:
First, you may receive some cash directly while you own the investment. This is called the income component of your return.
Second, the value of the asset you purchase often changes
Example of cash income component of return
Dividends paid
Total dollar return =
Equation
Dividend income + Capital gain (or loss)
Total cash if stock is sold =
Equation
Initial investment + Total return
Percentage return =
Equation
(Dividends paid at end of period + Change in market value over period) / Beginning market value
Six important types of financial investments
1) Canadian common stocks
2) U.S. common stocks.
3) TSX Venture stock
4) Small stocks.
5) Long bonds
6) Canada Treasury bills
Arithmetic average AKA arithmetic mean return
Add up all the individual numbers and divide by however many numbers you added up
This is the classic average
risk premium
The excess return required from an investment in a risky asset over a risk-free investment.
first lesson: risky assets, on average, earn a risk premium
Put another way, there is a reward for bearing risk.
Just to summarize, We have already seen that the year-to-year returns on common stocks tend to be more volatile than the returns on, say,
long-term bonds.
variance definition
The average squared deviation between the actual return and the average return.
The bigger this number is, the more the actual returns tend to differ from the average return
standard deviation definition
The positive square root of the variance.
Also, the larger the variance or standard deviation is, the more spread out the returns are
2 most commonly used methods to measure volatility
1) Variance
2) Standard deviation
Variance Information
essentially measures the average squared difference between the actual returns and the average return.
The bigger this number is, the more the actual returns tend to differ from the average return.
Also, the larger the variance or standard deviation is, the more spread out the returns are
To calculate variance
Actual return - Average return = Deviation
Deviation squared = Squared deviation
Actual return could be (0.10 + .12 + .03 - .09) so the average is 0.04
Now take each actual return and subtract the average return, then square that number
Add up all the squared deviations. Now take that number and divide it by the number of returns - 1 (so if you had 4 numbers to start with, only use 3). That number is your variance
To find the standard deviation
Take the square root of the variance
The sum of the deviations in the table should always equal
0
Normal Distribution (bell curve)
A symmetric, bell-shaped frequency distribution that can be defined by its mean and standard deviation
For example, with a normal distribution, the probability that we end up within one standard deviation of the average is about
two-thirds
The probability that we end up within two standard deviations is about
95%
Finally, the probability of being more than three standard deviations away from the average is less than _____
1%
value at risk (VaR)
Statistical measure of maximum loss used by banks and other financial institutions to manage risk exposures.
The Second Lesson
the greater the potential reward, the greater the risk
Geometric average return
The average compound return earned per year over a multi-year period.
Suppose you buy a particular stock for $200. Unfortunately, the first year you own it, it falls to $100. The second year you own it, it rises back to $200, leaving you where you started (no dividends were paid)
In this method you would recognize your returns as 0%
Arithmetic average return
The return earned in an average year over a multi-year period.
Suppose you buy a particular stock for $200. Unfortunately, the first year you own it, it falls to $100. The second year you own it, it rises back to $200, leaving you where you started (no dividends were paid)
In this method you would recognize your returns as 25%
(-50% + 100%) / 2 = 25%
The ________ approach answers the questions, “What was your average compound return per year over a particular period?”
Geometric average
The ________ approach answers the question, “What was your return in an average year over a particular period?”
arithmetic average
Suppose a particular investment had annual returns of 10%, 12%, 3%, and −9% over the last four years. The geometric average return over this four-year period is calculated as:
(1.10 x 1.12 x 1.03 x 0.91) ^ 1/4 - 1
= 3.66% or 0.0366
Suppose a particular investment had annual returns of 10%, 12%, 3%, and −9% over the last four years. The arithmetic average return over this four-year period is calculated as:
(.10 + .12 + .03 - .09) / 4
= 4% or 0.04
The geometric average return formula tells us four things:
1) Take each of the T annual returns R1, R2, …, RT and add a one to each (after converting them to decimals!).
2) Multiply all the numbers from step 1 together.
3) Take the result from step 2 and raise it to the power of 1/T.
4) Finally, subtract one from the result of step 3. The result is the geometric average return.
What average will always be small than the other?
thus far is that the geometric average returns seem to be smaller than the corresponding arithmetic average.
It turns out that this will always be true (as long as the returns are not all identical, in which case the two “averages” would be the same)
“average return,”
means arithmetic
efficient capital market
Market in which security prices reflect available information.
The Efficient Markets Hypothesis
The hypothesis is that actual capital markets, such as the TSX, are efficient.
Volatility is the concept that creates
risk
History of the market, what we have learned:
1) Government bonds and treasury bills pay lower returns than stocks
2) Venture stocks pay higher return than regulars blue chip stocks
Treasury bills are said to be
risk free
risk-free
It is common to distinguish among three forms of market efficiency:
1) weak form efficient
2) semistrong form efficient
3) strong form efficient
Strong form efficient
all information of every kind is reflected in stock prices. In such a market, there is no such thing as inside information
Semistrong form efficient
all public information is reflected in the stock price. The reason this form is controversial is that it implies that a security analyst who tries to identify mispriced stocks using, for example, financial statement information is wasting time because that information is already reflected in the current price.
Weak form efficient
at a minimum, the current price of a stock reflects its own past prices. In other words, studying past prices in an attempt to identify mispriced securities is futile if the market is weak form efficient
At the risk of going out on a limb, the evidence does seem to tell us three things
First, prices do appear to respond very rapidly to new information, and the response is at least not grossly different from what we would expect in an efficient market.
Second, the future of market prices, particularly in the short run, is very difficult to predict based on publicly available information.
Third, if mispriced stocks do exist, there is no obvious means of identifying them. Put another way, simple-minded schemes based on public information will probably not be successful
The greater the standard deviation the lower the risk
False
The larger the variance, the greater the risk of the investment.
True
The standard deviation can be negative, positive, or equal to zero.
False
Always must be positive
