Introduction to Corporate Finance

6: The Trade-Off Between Risk and Return

6-2b THE RISK DIMENSION

In both Figure 6.2 and Figure 6.3a, another important difference between the three asset classes

emerges. The line plotting the growth of one dollar invested in Treasury bills is relatively smooth. The

line for bonds moves up and down a little more, and the line representing common stocks looks very

jagged indeed. This implies that although a portfolio invested entirely in common stocks grows more

rapidly than a portfolio invested in either bonds or bills, the common stock portfolio displays more

dramatic ups and downs from year to year. In the long run, common stock investors may grow wealthier

than bond investors, but their path to riches is a bumpy one. Some investors may be willing to pass up

higher returns on stocks in exchange for the additional security of bonds or bills.

Figure 6.3b shows that the performance of the Australian market was similar to the US market, with

ordinary shares far outstripping the performance of bonds and notes. However, in contrast to Australian

equities, which displayed a much greater real value growth than US equities, Australian bonds and notes

underperformed the US market over this timeframe.

Table 6.1a summarises the information in Figures 6.2 and 6.3a. In both nominal and in real terms,

the average return on equities is far higher than the average return on Treasury bonds or bills.^7 However,

notice the difference in returns between the best and worst years for common stocks, and compare this

to the differences between the best and worst years for the other asset classes. In 1933, common stocks

experienced their highest nominal return of 57.6%, but that outstanding performance followed on the

heels of the worst year for stocks, 1931, with a nominal return of –43.9%. The difference in the best and

the worst in returns is more than 100%! In contrast, Treasury bills moved within a much narrower band,

with a top nominal return of 14.7% and a minimum nominal return of 0%.

7 The formula for calculating the average return is straightforward. If there are n years of historical data and the return in any particular year t is
rt, then the average return equals the sum of the individual returns divided by n:

Averagereturn==^1

∑rt

t

n

n

FIGURE 6.3A THE REAL VALUE OF US$1 INVESTED IN US STOCKS, US TREASURY BONDS, AND US BILLS, 1900–2014

The figure shows that US$1 invested in US common stocks in 1900 would have grown to a real value of US$1,396 by

2014. By comparison, a US$1 investment in US Treasury bonds or bills would have grown to just US$10.10 or US$2.70,
      respectively, by 2014.

1,396

10.1

2.7

0

1

10

100

1,000

10,000

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

Equities

Bonds

Bills

Source: Credit Suisse Global Investment Returns Yearbook 2015, by Elroy Dimson, Paul Marsh, and Mike Staunton, page 58.

Published by Credit Suisse Research Institute, February 2015. Reprinted with permission.

Because they are both issued

by the US government, are

the risks of Treasury bills and

Treasury bonds equal? Why or

why not?

thinking cap

question