Seventyfive Years Of Capital Market History In One Easy Lesson

Financial analysts are blessed with an enormous quantity of data on security prices and returns. For example, the University of Chicago's Center for Research in Security Prices (CRSP) has developed a file of prices and dividends for each month since 1926 for every stock that has been listed on the New York Stock Exchange (NYSE). Other files give data for stocks that are traded on the American Stock Exchange and the over-the-counter market, data for bonds, for options, and so on. But this is supposed to be one easy lesson. We, therefore, concentrate on a study by Ibbotson Associates that measures the historical performance of five portfolios of securities:

1. A portfolio of Treasury bills, i.e., United States government debt securities maturing in less than one year.

2. A portfolio of long-term United States government bonds.

3. A portfolio of long-term corporate bonds.1

4. Standard and Poor's Composite Index (S&P 500), which represents a portfolio of common stocks of 500 large firms. (Although only a small proportion of the 7,000 or so publicly traded companies are included in the S&P 500, these companies account for over 70 percent of the value of stocks traded.)

5. A portfolio of the common stocks of small firms.

These investments offer different degrees of risk. Treasury bills are about as safe an investment as you can make. There is no risk of default, and their short maturity means that the prices of Treasury bills are relatively stable. In fact, an investor who wishes to lend money for, say, three months can achieve a perfectly certain payoff by purchasing a Treasury bill maturing in three months. However, the investor cannot lock in a real rate of return: There is still some uncertainty about inflation.

By switching to long-term government bonds, the investor acquires an asset whose price fluctuates as interest rates vary. (Bond prices fall when interest rates rise and rise when interest rates fall.) An investor who shifts from government to

1The two bond portfolios were revised each year to maintain a constant maturity.

154 PART II Risk

Dollars 10,000

1,000

2,586.5 S&P 500 6,402.2 Small firms

64.1 Corporate bonds 48.9 Government bonds 16.6 Treasury bills

1926 1936 1946 1956 1966 1976 1986 2000

Year

2,586.5 S&P 500 6,402.2 Small firms

64.1 Corporate bonds 48.9 Government bonds 16.6 Treasury bills

1926 1936 1946 1956 1966 1976 1986 2000

Year

FIGURE 7.1

How an investment of $1 at the start of 1926 would have grown, assuming reinvestment of all dividend and interest payments.

Source: Ibbotson Associates, Inc., Stocks, Bonds, Bills, and Inflation, 2001 Yearbook, Chicago, 2001; cited hereafter in this chapter as the 2001 Yearbook. © 2001 Ibbotson Associates, Inc.

corporate bonds accepts an additional default risk. An investor who shifts from corporate bonds to common stocks has a direct share in the risks of the enterprise.

Figure 7.1 shows how your money would have grown if you had invested $1 at the start of 1926 and reinvested all dividend or interest income in each of the five portfolios.2 Figure 7.2 is identical except that it depicts the growth in the real value of the portfolio. We will focus here on nominal values.

Portfolio performance coincides with our intuitive risk ranking. A dollar invested in the safest investment, Treasury bills, would have grown to just over $16 by 2000, barely enough to keep up with inflation. An investment in long-term Treasury bonds would have produced $49, and corporate bonds a pinch more. Common stocks were in a class by themselves. An investor who placed a dollar in the stocks of large U.S. firms would have received $2,587. The jackpot, however, went to investors in stocks of small firms, who walked away with $6,402 for each dollar invested.

Ibbotson Associates also calculated the rate of return from these portfolios for each year from 1926 to 2000. This rate of return reflects both cash receipts— dividends or interest—and the capital gains or losses realized during the year. Averages of the 75 annual rates of return for each portfolio are shown in Table 7.1.

2Portfolio values are plotted on a log scale. If they were not, the ending values for the two common stock portfolios would run off the top of the page.

CHAPTER 7 Introduction to Risk, Return, and the Opportunity Cost of Capital 155

Capital Market History

How an investment of $1 at the start of 1926 would have grown in real terms, assuming reinvestment of all dividend and interest payments. Compare this plot to Figure 7.1, and note how inflation has eroded the purchasing power of returns to investors.

Source: Ibbotson Associates, Inc., 2001 Yearbook. © Ibbotson Associates, Inc.

How an investment of $1 at the start of 1926 would have grown in real terms, assuming reinvestment of all dividend and interest payments. Compare this plot to Figure 7.1, and note how inflation has eroded the purchasing power of returns to investors.

Source: Ibbotson Associates, Inc., 2001 Yearbook. © Ibbotson Associates, Inc.

Average Annual Rate of Return

Average Risk Premium

Average Annual Rate of Return

Average Risk Premium

Portfolio

Nominal

Real

(Extra Return Versus Treasury Bills)

Treasury bills

3.9

.8

0

Government bonds

5.7

2.7

1.8

Corporate bonds

6.0

3.0

2.1

Common stocks (S&P 500)

13.0

9.7

9.1

Small-firm common stocks

17.3

13.8

Average rates of return on Treasury bills, government bonds, corporate bonds, and common stocks, 1926-2000 (figures in percent per year).

Source: Ibbotson Associates, Inc., 2001 Yearbook.

TABLE 7.1

Average rates of return on Treasury bills, government bonds, corporate bonds, and common stocks, 1926-2000 (figures in percent per year).

Source: Ibbotson Associates, Inc., 2001 Yearbook.

Since 1926 Treasury bills have provided the lowest average return—3.9 percent per year in nominal terms and .8 percent in real terms. In other words, the average rate of inflation over this period was just over 3 percent per year. Common stocks were again the winners. Stocks of major corporations provided on average a risk premium of 9.1 percent a year over the return on Treasury bills. Stocks of small firms offered an even higher premium.

You may ask why we look back over such a long period to measure average rates of return. The reason is that annual rates of return for common stocks fluctuate so

156 PART II Risk much that averages taken over short periods are meaningless. Our only hope of gaining insights from historical rates of return is to look at a very long period.3

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