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Chapter 5

Risk, Return, and the

Historical Record

INVESTMENTS
TWELFTH EDITION
BODIE, KANE, MARCUS

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 Chapter Overview

Present tools for estimating expected returns and risk from

the historical record
• Interest rates and investments in safe assets
• History of risk-free investments in the U.S.

• Scenario analysis of risky investments and the data inputs

necessary to conduct it

Develop statistical tools needed to make inferences from

historical time series of portfolio returns

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 Interest Rates and Inflation Rates

Fundamental factors that determine the level of interest rates:

1. Supply of funds from savers, primarily households
2. Demand for funds from businesses to be used to finance
investments in plant, equipment, and inventories
3. Government’s net demand for funds as modified by
actions of the Federal Reserve Bank
4. Expected rate of inflation

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 Real and Nominal Rates of Interest

A nominal interest rate is the growth rate of your money

A real interest rate is the growth rate of your purchasing

power

rnom  Nominal Interest Rate

rreal  Real Interest Rate
i  Inflation Rate
rnom  i
rreal 
1 i

Note : rreal  rnom  i

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 Determination of the Equilibrium Real Rate of Interest

Figure 5.1 Determination of the equilibrium real rate of interest

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 Interest Rates and Inflation

We expect higher nominal interest rates when inflation is

higher

If E(i) denotes current expectations of inflation, the Fisher

hypothesis is

rnom  rreal  E  i 

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 Taxes and the Real Interest Rate

Tax liabilities are based on nominal income and the tax rate
determined by the investor’s tax bracket

rnom  Nominal Interest Rate

rreal  Real Interest Rate
i  Inflation Rate
t  Tax Rate
rnom  1  t   i   rreal  i   1  t   i  rreal 1  t   i  t

After-tax return falls by the tax rate times the inflation rate

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 Bills and Inflation, 19 26 to 20 18

Fisher equation
• Predicts the nominal rate of interest should track the
inflation rate, leaving the real rate somewhat stable
• Appears to work far better when inflation is more
predictable and investors can more accurately gauge the
nominal interest rate they require to provide an acceptable
real rate of return

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 T-Bill Rates, Inflation Rates, and Real Rates, 19 26 to 20
18

Average Annual Rates Standard Deviation

T-Bills Inflation Real T-Bill T-Bills Inflation Real T-Bill

Full sample 3.38 3.01 0.46 3.12 4.00 3.76

1927 to 951 0.95 1.79 −0.47 1.24 6.04 6.33

1952 to 2018 4.29 3.46 0.81 3.13 2.84 2.12

Source: Annual rates of return from rolling over 1-month T-bills: Kenneth
French; annual inflation rates: Bureau of Labor Statistics.

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 Interest Rates and Inflation, 1926 to 2018

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 Effective Annual Rate (EAR) and Annual Percentage Rate
(APR)

Effective annual rates (EAR) explicitly account for compound

interest
n
 APR 
1  Ear  1  
 n 

Annual percentage rates (APR) are annualized using simple

rather than compound interest

APR  n  [(1  EAR)1/ n  1]

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 Risk and Risk Premiums: Holding Period Returns

Sources of investment risk

• Macroeconomic fluctuations
• Changing fortunes of various industries
• Firm-specific unexpected developments
Holding period return (HPR), or realized rate of return, is
based on the price per share at year’s end and any cash
dividends collected

Ending price of a share  Beginning price  Cash dividend

HPR 
Beginning price

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 Risk and Risk Premiums: Expected Return and Standard
Deviation 1

Expected returns

E (r )   p ( s )  r ( s )
s

• p(s) = probability of each scenario

• r(s) = HPR in each scenario
• s = scenario

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 Risk and Risk Premiums: Expected Return and Standard
Deviation 2

Variance (VAR):

2
   p  s    r  s   E  r 
2

Standard Deviation (STD):

STD   2

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 Risk and Risk Premiums: Excess Returns and Risk
Premiums

Risk premium is the difference between the expected HPR

and the risk-free rate
• Provides compensation for the risk of an investment
Risk-free rate is the rate of interest that can be earned with
certainty
• Commonly taken to be the rate on short-term T-bills

Difference between actual rate of return and risk-free rate is

called excess return

Risk aversion dictates the degree to which investors are

willing to commit funds to stocks

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 Learning from Historical Returns

Expected Returns and the Geometric (Time-

Arithmetic Average Weighted) Average Return
• When using historical data, • Geometric rate of return
each observation is treated • Intuitive measure of
as an equally likely performance over the sample
“scenario” period is the (fixed) annual
• Expected return, E(r), is HPR that would compound
over the period to the same
estimated by arithmetic terminal value obtained from
average of sample rates of the sequence of actual returns
return in the time series
n 1 n
E (r )   p ( s )r ( s )   r ( s) (1  g ) n  Terminal value
s 1 n s 1
 Arithmetic average of historic rates of return g  Terminal value1/n  1

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 Learning from Historical Returns: Variance and Standard
Deviation

Estimated variance
• Expected value of squared deviations

1 n
ˆ   [r ( s )  r ]2
2
n s 1

Unbiased estimated standard deviation

1 n 2
ˆ   [r ( s)  r ]
n  1 j 1

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 Learning from Historical Returns: The Reward-to-
Volatility (Sharpe) Ratio

Investors price risky assets so that the risk premium will be

commensurate with the risk of expected excess returns
• Best to measure risk by the standard deviation of excess,
not total, returns
Sharpe ratio
• Evaluates performance of investment managers

Risk premium
Sharpe ratio=
SD of excess return

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 The Normal Distribution 1

Figure 5.3 The normal distribution with mean 10% and standard
deviation 20%.

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 The Normal Distribution 2

Normal distribution is a bell-shaped probability distribution

that characterizes many natural phenomena
• For example, heights and weights of newborns, test
scores, etc.
Investment management is more manageable when returns
can be well approximated by the normal distribution
• Symmetric
• Stable
• Only mean and standard deviation are needed to estimate
future scenarios
• Statistical relation between returns can be summarized
with a single correlation coefficient
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 Deviations from Normality and Tail Risk

Skewness Kurtosis
• Standard measure of • Kurtosis concerns the
asymmetry in the likelihood of extreme
probability distribution of values on either side of
returns is called the skew the mean at the expense
of the distribution of a smaller likelihood of
moderate deviations
• STD (Sharpe ratio) no
longer a complete measure • Measures the degree of fat
of risk (performance) tails

 RR 4
 RR 3
  Kurtosis  Average 
   3
Skew  Average   ˆ 4 
 ˆ 3 
   

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 Skewness and Kurtosis

Normal and Skewed Normal and Fat-Tailed

Distributions Distributions

(mean = 6%, SD = 17%) (mean = .1, SD = .2)

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 Normality and Risk Measures: Downside Risk

Measures of downside risk

• Value at risk (VaR)
• Loss that will be incurred in the event of an extreme adverse price
change with some given, usually low, probability

• Expected shortfall (ES)

• Expected loss on a security conditional on returns being in the left
tail of the probability distribution

• Lower partial standard deviation (LPSD)

• SD computed using only the portion of the return distribution below
a threshold such as the risk-free rate of the sample average

• Relative frequency of large, negative 3-sigma returns

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 Historic Returns on Risky Portfolios

T-Bills T-Bonds Stocks

Average 3.38% 5.58% 11.72%
Risk premium N/A 2.45 8.34
Standard deviation 3.12 11.59 20.05
Max 14.71 41.68 57.35
Min −0.02 −25.96 −44.04

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 Historic Returns on Risky Portfolios: A Global View of
the Historical Record

Century-plus-long history (1900 to 2017) of average excess

returns in 20 stock markets
• Mean annual excess return across these countries was
7.4% and the median was 6.6%
• U.S. performance consistent with international experience

Tremendous variability in year-by-year returns

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 Average Excess Returns in 20 Countries, 1900 to 2017

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 Normality and Long-Term Investments

Lognormal distribution
• Probability distribution that characterizes a variable whose
log has a normal (bell-shaped) distribution
• Use of continuously compounded returns instead of
effective annual returns

Short-run versus long-run risk

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