Introduction to Corporate Finance

6: The Trade-Off Between Risk and Return

6-2 THE HISTORY OF RETURNS (OR, HOW

TO GET RICH SlOWlY)

The British author Aldous Huxley once wrote, ‘That men do not learn very much from the lessons of

history is the most important of all lessons that history has to teach us.’ We are more optimistic that what

we can learn from the history of financial markets benefits investors who study that history. Perhaps

the most important lesson is that an unavoidable trade-off exists between risk and return, so investors

seeking higher returns almost always have to accept higher risk.

6-2a NOMINAl AND REAl RETURNS ON SHARES,

BONDS AND BIllS

Figure 6.2 shows how a $1 investment in each of three different asset classes grew over 111 years in

the United States.^3 The three types of investments shown in the figure are Treasury bills, Treasury bonds

and ordinary shares.^4

Recall from Chapter 4 that Treasury bills mature in one year or less, and thus are not highly sensitive

to interest rate movements.^5 Treasury bonds are long-term instruments, so their prices can fluctuate

dramatically as interest rates change. Common stocks are the riskiest of the three investments. As you know

by now, the performance of a particular share depends on the ability of the company to generate cash.

Investors have no guarantee when they buy shares that they will perform well.

A quick glance at Figure 6.2 reveals that from 1900 to 2010, common stocks far outperformed Treasury

bonds and bills.^6 One US dollar invested in a portfolio of common stocks in 1900 grew to $21,481 by the

end of 2010. In contrast, an investment of US$1 in T-bonds or T-bills grew to just US$294 or US$71,

3 The term ‘asset class’ simply refers to a distinct type of investment or to a group of assets that share common characteristics.

4 Common stocks are the US equivalent of Australian ordinary shares. Common stocks are usually considered to be a separate asset class, but

they are a form of equity investment, so may be classed as equities. Treasury bills are the US equivalent of Australian Treasury notes. Bills

and bonds are forms of debt investment and may be referred to as debt securities or fixed income assets. Bills and notes are short-dated,

while bonds are issued with a longer time to maturity.

5 Or, using terms we have learned, they carry negligible interest rate risk. In August 2011, the rating agency Standard & Poor’s downgraded its

rating on US government securities, suggesting that these securities were no longer free of default risk.

6 The lines in this figure incorporate both the income component and the capital gain component of returns, and they assume that the initial

investment and the total dollar return on each asset are reinvested each year.

LO6.2

CONCEPT REVIEW QUESTIONS 6-1

1 In Chapter 4, we defined several bond return measures, including the coupon, the coupon rate,

the coupon yield and the yield to maturity. Indicate whether each of these measures: (a) focuses on

the total return or just one of the components of total return; and (b) focuses on dollar returns or

percentage returns.

2 You buy a share for $40. During the next year, it pays a dividend of $2, and its price increases to

$44. Calculate the total dollar and total percentage returns, and show that each of these is the sum

of the dividend and capital gain components.

Treasury bills

Treasury bills are the US

equivalent of Australian

Treasury notes. They are a

form of debt investment and

may be referred to as debt

securities or fixed income

assets

common stocks

Common stocks are the US

equivalent of Australian

ordinary sharesCommon

stocks are usually considered

to be a separate asset class,

but they are a form of equity

investment, so may be classed

as equities