Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

V. Risk and Return 12. Some Lessons from

Capital Market History

© The McGraw−Hill^421

Companies, 2002

AVERAGE RETURNS: THE FIRST LESSON

As you’ve probably begun to notice, the history of capital market returns is too compli-

cated to be of much use in its undigested form. We need to begin summarizing all these

numbers. Accordingly, we discuss how to go about condensing the detailed data. We

start out by calculating average returns.

Calculating Average Returns

The obvious way to calculate the average returns on the different investments in Table

12.1 is simply to add up the yearly returns and divide by 75. The result is the historical

average of the individual values.

For example, if you add up the returns for the large-company stocks in Figure 12.5

for the 75 years, you will get about 9.75. The average annual return is thus 9.75/75 

13.0%. You interpret this 13 percentjust like any other average. If you were to pick a

year at random from the 75-year history and you had to guess what the return in that

year was, the best guess would be 13 percent.

Average Returns: The Historical Record

Table 12.2 shows the average returns for the investments we have discussed. As shown,

in a typical year, the small-company stocks increased in value by 17.3 percent. Notice

also how much larger the stock returns are than the bond returns.

392 PART FIVE Risk and Return

FIGURE 12.8

 15

1925 1935 1945 1955 1965 1975 1985 1995 2000

20

 10

 5

5

10

15

0

Total

returns (%)

Inflation

Source: ©Stocks, Bonds, Bills, and Inflation 2001 Yearbook™, Ibbotson Associates, Inc., Chicago (annually

updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.

Year-to-Year Inflation: 1926–2000

12.3