PART 2: VAlUATION, RISK AND RETURNBy now, the most important lesson from the history of financial markets should be clear: there is a
positive relationship between risk and return. Asset classes that experience more ups and downs offer
investors higher returns, on average, than investments that provide more stable returns. As yet, we have
not precisely defined the term risk, but you probably expect that ‘risk’ must capture the uncertainty
surrounding an investment’s performance. Table 6.1a indicates that T-bill returns are more predictable
than T-bond returns, and that both are more predictable than stock returns.
The trade-off between risk and return leads us to an important concept known as a risk premium.
The risk premium is the additional return offered by a more risky investment relative to a safer one.
Table 6.2 reports several risk premiums by taking the differences between average stock, T-bond and
T-bill returns, as reported in Table 6.1a. Common stocks offer an average 7.5% higher return than that
on Treasury bills. The risk premium on equities
relative to bonds averages 5.8%.
Keep in mind that the relationship between risk
and return suggests that riskier assets pay higher
returns on average, but not necessarily every single
year. If it is true that, on average, riskier investments
pay higher returns than safer ones, then we can
use historical risk premiums as a starting point to
determine what returns we might expect in the
future on alternative investments. Perhaps the most
important reason to study the lessons of history in
financial markets is to make better guesses about
what the future holds.exampleSuppose you want to construct a forecast for the
return on US stocks for the next year. One approach
is to use the average historical value, 11.4% (from
Table 6.1a), as your forecast. A problem with this
method is that 11.4% represents an average over
many years, some of them having high inflation and
some experiencing low inflation. Similarly, in some past
years, interest rates on bonds and bills were relatively
high; in other years, rates were much lower. You can
make use of current market information to construct a
better forecast than the average historical return.For example, suppose you look at Treasury bills
trading in the market at the time that you want to
develop a forecast for equity returns. At that time,
you find that Treasury bills offer a yield to maturity of
about 1%. From Table 6.2, you see that the average risk
premium on equities relative to T-bills is 7.5%. Add that
premium to the current Treasury bill yield to arrive at
a forecast for equity returns of 8.5% (1% + 7.5%). This
should be a superior forecast compared to the simple
historical average because the estimate of 8.5% reflects
current market conditions (such as expected inflation
rates and required returns on low-risk investments).Analysts use data on risk premiums for many different purposes. In Chapter 4, we saw that bonds
receiving lower ratings from bond-rating agencies must pay higher yields. Bond traders know this, and use
data on the risk premium between relatively safe bonds (such as Treasury bonds or AAA-rated corporate
bonds) and riskier bonds to price complex financial instruments. As we will see in later chapters, corporate
executives use the risk premium on equities relative to Treasury securities to estimate the rate of return that
their investors expect on major capital expenditures. We will return to the subject of the equity risk premium
several times in this book, but next, we need to explore the meaning of the word risk in more depth.risk premium
The additional return offered
by a more risky investment
relative to a safer oneTABlE 6.2 RISK PREMIUMS FOR US STOCKS,
US BONDS AND US BILLS, 1900–2010
The risk premium refers to the additional return offered by
an investment, relative to an alternative, because it is more
risky than the alternative. Stocks offer a risk premium
over Treasury bonds and bills, and T-bonds offer a risk
premium over T-bills.Comparison Risk premium (%)
Stocks – bills 11.4 – 3.9 = 7.5
Stocks – bonds 11.4 – 5.6 = 5.8
Bonds – bills 5.6 – 3.9 = 1.7Source: Elroy Dimson, Paul Marsh and Mike Staunton, ‘Triumph of the Optimists,’
Global Investment Returns Yearbook 2010. Published by ABN AMRO, London.
Updates provided by Dimson et al. to 2009. Reprinted with permissionElroy Dimson,
London Business School
‘The worldwide average
equity premium has
been somewhere in the
4 to 5% range.’
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