Chapter 8 Risk and Rates of Return 231(^2) The graph re" ects stock prices; dividends are not included. If dividends were included, the percentage gains
would be somewhat higher.
compensate for the risk, people will start buying it, raising its price and thus lower-
ing its expected return. The stock will be in equilibrium, with neither buying nor
selling pressure, when its expected return is exactly su$ cient to compensate for its
risk.
- Stand-alone risk, the topic of Section 8-2, is important in stock analysis primarily
as a lead-in to portfolio risk analysis. However, stand-alone risk is extremely
important when analyzing real assets such as capital budgeting projects.
When you " nish this chapter, you should be able to:
- Explain the di! erence between stand-alone risk and risk in a portfolio context.
- Explain how risk aversion a! ects a stock’s required rate of return.
- Discuss the di! erence between diversi" able risk and market risk, and explain how
each type of risk a! ects well-diversi" ed investors.- Explain what the CAPM is and how it can be used to estimate a stock’s required
rate of return.- Discuss how changes in the general stock and the bond markets could lead to
changes in the required rate of return on a " rm’s stock.- Discuss how changes in a " rm’s operations might lead to changes in the required
rate of return on the " rm’s stock.8-1 STOCK PRICES OVER THE LAST 20 YEARS
Figure 8-1 gives you an idea about how stocks have performed over the period
from 1988 through 2007.^2 The top graph compares General Electric (GE), the
broad stock market as measured by the S&P 500, and General Motors (GM). GE
illustrates companies that have done well, GM illustrates those that have not
done well, and the S&P 500 shows how an average company has performed.
Most stocks climbed sharply until 2000 (Market 1 in the vignette), then dropped
equally sharply during Market 2, then rose nicely through most of Market 3.
Since there are thousands of stocks, we could have shown many different pic-
tures, with some rising much faster than GE and others falling much faster than
GM—with some going to zero and vanishing. Most of the indexes rise and fall
together; but if we had shown the Nasdaq index, it would have looked a great
deal like GE, rising much faster than the S&P but then falling faster later on. Also
note that the beginning and ending dates can lead to totally different “pictures”
of stocks’ performances. If we had started in 1990 and ended in 2000, it would
have looked as though stocks were wonderful investments. On the other hand, if
we had started in 2000 and ended in 2003, it would have looked as though stocks
were a terrible place to put our money. It would be great if we knew when to get
in and out of the market.
The lower graph shows GE’s P/E ratio. The P/E ratio depends on a number
of factors, including fundamental factors such as interest rates and earnings
growth rates; but it also re! ects investors’ optimism or pessimism—or in Alan
Greenspan’s words, their “irrational exuberance or pessimism.” Security analysts
and investors forecast the future, but they seem to be overly optimistic at certain
times and overly pessimistic at other times. Looking back, we can see that they
were overly optimistic in 2000. But what about in 1997? There had been a sharp
run-up to that time, and some “experts” thought the market was at a top and rec-
ommended getting out. Those experts turned out to be wrong, and they “left a lot
of money on the table.”