Introduction to Corporate Finance

6: The Trade-Off Between Risk and Return

In 1999, just the reverse was true, with stock returns far above their long-term average and bond returns

falling well below normal. These examples illustrate an important point to which we will return later in

this chapter: assets do not always move together. When one investment performs unusually well, other

investments may earn low returns. Investors can benefit from the fact that different assets do not always

move in tandem. We will see why this is so when we discuss diversification in Section 6-4.

FIGURE 6.4 NOMINAL RETURNS ON STOCKS, TREASURY BONDS AND BILLS, 1900–2010

The dots in the figure show the return on each asset class in every year from 1900-2010. Notice that common stock returns

are riskier, because they cover a wider range than returns on Treasury bonds or bills. Common stocks also earn the

highest average returns.

Average 5.6%

Average 3.9%

Type of asset

Return (%)

–45.0%

–30.0%

–15.0%

0.0%

15.0%

30.0%

45.0%

60.0%

Stocks Bonds Bills

1999

Average 11.4%

2008

2008

2010

1999

Source: Elroy Dimson, Paul Marsh and Mike Staunton, ‘Triumph of the Optimists,’ Global Investment Returns Yearbook 2010. ABN AMRO,

London. Updates provided by Dimson, et al. to 2009. Author’s estimates for 2010. Reprinted with permission