Chapter 10 Some Lessons from Capital Market History
Chapter 10—Some Lessons from Capital Market History
The concepts of risk and return generally go hand in hand.In Chapter 10 we first discovered that any form of financial gain from an investment is considered your return on the asset.This return is made up of two components: dollar return and capital gain.Dollar return comprises the cash you receive with respect to holding that particular investment.The change in the value of the asset you hold is the capital gain.A general example is the purchase of a rental property, where the rent is the income return and the growth in value is the capital gain.Total return represents the income component plus the capital growth (or loss).
When we are examining figures, we must establish whether the figures are expressed on a nominal or real return basis.Nominal returns are returns that are not adjusted for inflation, whereas real returns are adjusted based on the level of inflation.Real returns give a true reflection of the return.
The two important concepts that we have established in this chapter can be summarised as follows:
- Risky assets earn a risk premium.Therefore, we may establish that, generally, the higher the risk one incurs, the higher the expected return.Put another way, we can see that the more risk that an individual is willing to undertake, the higher their expected reward.A prime example is the comparison between the share market and the fixed-interest market.The share market is generally riskier, so one can expect higher returns in comparison to the fixed interest market.An investor needs to establish that there is a substantial benefit in investing in the riskier investment versus the safe, low-yielding fixedinterest market.
- Variance is closely associated with risk and return.We can establish that the greater the variance or standard deviation, the greater the risk of an investment. The greater the variability, the greater the risk.
In this chapter we also examine the capital market efficiency theory.The capital market efficiency theory is based on the idea that the share price of a firm is a reflection of all available information (e.g. historical, public, and private) in the marketplace.
The efficient market hypothesis was pioneered by the Eugene Fama in 1970 and is based on the idea that capital markets are efficient, and that all values in a market are a reflection of investors’ knowledge of information in that particular market.If prices are neither too low nor too high, then the difference between the market value of an investment and its cost is zero; hence the NPV is zero.Ironically, competition among investors trying to beat the market is in fact what actually keeps the market in equilibrium and therefore, efficient.
There are various forms of market efficiency:
weak-form—the current price of a security reflects its own past prices.
semi-strong form—all historical and public information is reflected in the security price.
strong-form—all available information (historical, public, and private) is reflected in the security price.
The article ‘Baked beans a lot more predictable than shares’ appeared in The Sydney Morning Herald[*] on 11 March 2006 and reflects the above-mentioned issues.
Considering the above information and the article from The Sydney Morning Herald, complete the following seven questions.
Question 1
Define the concept of risk.How are the concepts of risk and return related?
Question 2
Total return is made up of which two components? Discuss the difference between these two components.
Question 3
What is the difference between nominal returns and real returns? Which is the best measure to use when judging returns?
Question 4
In the article ‘Baked beans a lot more predictable than shares’ in The Sydney Morning Herald, what issues are being discussed with respect to the concepts of risk and return? Why do investors need to look to greater risks to establish greater returns?
Question 5
Describe the capital market efficiency theory.Do you think this theory holds with respect to our own capital markets?If not, why not?
Question 6
If Fama’s Efficient Market Hypothesis is correct and the share market is efficient, why do prices change daily?
Question 7
In recent yearsthe Australian stock market, on the back of a commodities boom and strong financial conditions, has increased in value with considerable gains being made by all of its participants.How is this possible in an efficient market?
1
Online case studies Fundamentals of Corporate Finance 4e by Ross et al.
[*] See file ‘C10_article’.