Chapter 12: Lessons from Capital Marketing History

Question 1

Return on your investment definition

Answer 1

If you buy an asset of any sort, your gain (or loss) from that investment

Question 2

This return usually has two components:

Answer 2

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

Question 3

Example of cash income component of return

Answer 3

Dividends paid

Question 4

Total dollar return =

Equation

Answer 4

Dividend income + Capital gain (or loss)

Question 5

Total cash if stock is sold =

Equation

Answer 5

Initial investment + Total return

Question 6

Percentage return =

Equation

Answer 6

(Dividends paid at end of period + Change in market value over period) / Beginning market value

Question 7

Six important types of financial investments

Answer 7

1) Canadian common stocks
2) U.S. common stocks.
3) TSX Venture stock
4) Small stocks.
5) Long bonds
6) Canada Treasury bills

Question 8

Arithmetic average AKA arithmetic mean return

Answer 8

Add up all the individual numbers and divide by however many numbers you added up

This is the classic average

Question 9

risk premium

Answer 9

The excess return required from an investment in a risky asset over a risk-free investment.

Question 10

first lesson: risky assets, on average, earn a risk premium

Answer 10

Put another way, there is a reward for bearing risk.

Question 11

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,

Answer 11

long-term bonds.

Question 12

variance definition

Answer 12

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

Question 13

standard deviation definition

Answer 13

The positive square root of the variance.

Also, the larger the variance or standard deviation is, the more spread out the returns are

Question 14

2 most commonly used methods to measure volatility

Answer 14

1) Variance

2) Standard deviation

Question 15

Variance Information

Answer 15

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

Question 16

To calculate variance

Answer 16

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

Question 17

To find the standard deviation

Answer 17

Take the square root of the variance

Question 18

The sum of the deviations in the table should always equal

Answer 18

0

Question 19

Normal Distribution (bell curve)

Answer 19

A symmetric, bell-shaped frequency distribution that can be defined by its mean and standard deviation

Question 20

For example, with a normal distribution, the probability that we end up within one standard deviation of the average is about

Answer 20

two-thirds

Question 21

The probability that we end up within two standard deviations is about

Answer 21

95%

Question 22

Finally, the probability of being more than three standard deviations away from the average is less than _____

Answer 22

1%

Question 23

value at risk (VaR)

Answer 23

Statistical measure of maximum loss used by banks and other financial institutions to manage risk exposures.

Question 24

The Second Lesson

Answer 24

the greater the potential reward, the greater the risk

Question 25

Geometric average return

Answer 25

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%

Question 26

Arithmetic average return

Answer 26

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%

Question 27

The ________ approach answers the questions, “What was your average compound return per year over a particular period?”

Answer 27

Geometric average

Question 28

The ________ approach answers the question, “What was your return in an average year over a particular period?”

Answer 28

arithmetic average

Question 29

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:

Answer 29

(1.10 x 1.12 x 1.03 x 0.91) ^ 1/4 - 1

= 3.66% or 0.0366

Question 30

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:

Answer 30

(.10 + .12 + .03 - .09) / 4

= 4% or 0.04

Question 31

The geometric average return formula tells us four things:

Answer 31

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.

Question 32

What average will always be small than the other?

Answer 32

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)

Question 33

“average return,”

Answer 33

means arithmetic

Question 34

efficient capital market

Answer 34

Market in which security prices reflect available information.

Question 35

The Efficient Markets Hypothesis

Answer 35

The hypothesis is that actual capital markets, such as the TSX, are efficient.

Question 36

Volatility is the concept that creates

Answer 36

risk

Question 37

History of the market, what we have learned:

Answer 37

1) Government bonds and treasury bills pay lower returns than stocks
2) Venture stocks pay higher return than regulars blue chip stocks

Question 38

Treasury bills are said to be

Answer 38

risk free

risk-free

Question 39

It is common to distinguish among three forms of market efficiency:

Answer 39

1) weak form efficient
2) semistrong form efficient
3) strong form efficient

Question 40

Strong form efficient

Answer 40

all information of every kind is reflected in stock prices. In such a market, there is no such thing as inside information

Question 41

Semistrong form efficient

Answer 41

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.

Question 42

Weak form efficient

Answer 42

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

Question 43

At the risk of going out on a limb, the evidence does seem to tell us three things

Answer 43

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

Question 44

The greater the standard deviation the lower the risk

Answer 44

False

Question 45

The larger the variance, the greater the risk of the investment.

Answer 45

True

Question 46

The standard deviation can be negative, positive, or equal to zero.

Answer 46

False

Always must be positive