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11.5 Market History

PLEASE NOTE: This book is currently in draft form; material is not final.

Learning Objective

  1. Describe the historical relationship between return and risk for various financial assets.

Over the past few chapters, we have explored different types of financial assets. At this point, it is worth looking at how some of these assets have performed historically.

Table 11.1 Historical Returns and Standard Deviations: Summary Statistics of Annual Total Return, 1926–2010

Arithmetic Mean Standard Deviation
Small Company Stocks 16.7% 32.6%
Large Company Stocks 11.9% 20.4%
Long-Term Corporate Bonds 6.2% 8.3%
Long-Term Government Bonds 5.9% 9.5%
Immediate-Term Government Bonds 5.5% 5.7%
U.S. Treasury Bills 3.7% 3.1%
Inflation 3.1% 4.2%

We see that there is a very strong relationship between the average return and the level of risk (as measured by standard deviation). This corresponds with our understanding that most investors are risk averse; that is, to accept a larger degree of risk (a higher standard deviation) investors demand a larger return. Also, this figure matches our intuition that stocks are riskier than bonds.

While this data is a good starting point for those trying to determine future investor expectations, there are some large caveats. Remember that, during this time period, the United States rose to be one of (if not the only) world “superpowers”. We have no idea what this data would look like if, for instance, the Axis nations won WWII or the Soviet Union still existed. Depending upon these trends to continue might be a mistake, since the world continues to change politically, economically, and culturally.

Key Takeaways

  • The higher the risk, the higher the expected return (usually).
  • Historical results are not a guarantee of future performance! (We realize we’re repeating ourselves, but we want to underscore this very crucial fact.)

Exercises

  1. Is there any portion of the historical data that has a surprising result (that is, contrary to our expectations)?