Using Capital Market History

Based on the discussion in this section, you should begin to have an idea of the risks and rewards from investing. For example, in mid-2001, Treasury bills were paying about 3.5 percent. Suppose we had an investment that we thought had about the same risk as a portfolio of large-firm common stocks. At a minimum, what return would this investment have to offer for us to be interested?

From Table 12.3, we see that the risk premium on large-company stocks has been 9.1 percent historically, so a reasonable estimate of our required return would be this premium plus the T-bill rate, 3.5% + 9.1% = 12.6%. This may strike you as being high, but, if we were thinking of starting a new business, then the risks of doing so might resemble those of investing in small-company stocks. In this case, the historical risk premium is 13.4 percent, so we might require as much as 16.9 percent from such an investment at a minimum.

We will discuss the relationship between risk and required return in more detail in the next chapter. For now, you should notice that a projected internal rate of return, or IRR, on a risky investment in the 15 to 25 percent range isn't particularly outstanding. It depends on how much risk there is. This, too, is an important lesson from capital market history.

Investing in Growth Stocks

The term growth stock is frequently used as a euphemism for small-company stock. Are such investments suitable for "widows and orphans"? Before answering, you should consider the historical volatility. For example, from the historical record, what is the approximate probability that you will actually lose more than 16 percent of your money in a single year if you buy a portfolio of stocks of such companies?

Looking back at Figure 12.10, we see that the average return on small-company stocks is 17.3 percent and the standard deviation is 33.4 percent. Assuming the returns are approximately normal, there is about a 1/3 probability that you will experience a return outside the range of -16.1 to 50.7 percent (17.3% ± 33.4%).

Because the normal distribution is symmetric, the odds of being above or below this range are equal. There is thus a 1/6 chance (half of 1/3) that you will lose more than 16.1 percent. So you should expect this to happen once in every six years, on average. Such investments can thus be very volatile, and they are not well suited for those who cannot afford the risk.

© The McGraw-Hill

Companies, 2002

EXAMPLE 12.3 |

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

V. Risk and Return

12. Some Lessons from Capital Market History

© The McGraw-Hill Companies, 2002

CHAPTER 12 Some Lessons from Capital Market History

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