Introduction to Corporate Finance

6: The Trade-Off Between Risk and Return

is irrelevant because diversification eliminates unsystematic risks. How difficult is it for investors to remove

exposure to unsystematic risk? In fact, it is very easy for them to do so. The mutual fund industry is built

on the idea of allowing many investors to pool their money so that even people with relatively little money

to invest can buy a stake in a well-diversified portfolio. This chapter’s ‘What companies do’ box shows that

it is possible to eliminate some unsystematic risk by diversifying globally.

finance in practice

INVESTMENT RETURNS AROUND THE WORLD

The following chart summarises the historical

performance of equities, bonds and bills for various

countries around the world. It shows that Australian

equities have substantially outperformed most other

markets.

The tendency for shares to outperform safer

investments like Treasury bills and bonds is a

common phenomenon. As the table shows, the

premium on equities relative to bills and relative to

bonds was positive for all other countries assessed

from 1900–2010. The relative performance of

equities compared to both bills and bonds was

highest in Australia and lowest in Denmark.

The second column of numbers shows the

historical standard deviation of equities in each

country. Finland, Germany, Japan and Italy had the

most volatile share markets over the past century,

but notice how many markets around the world had

a standard deviation very close to that of the US

market. Even more important, look at the bottom

row of the table, which calculates the average real

return, standard deviation and equity risk premium

for a portfolio containing shares from all the

countries. The world portfolio’s standard deviation

was just 17.7%. Only the Canadian share market

was less volatile than the world market as a whole.

Source: Adapted from Elroy Dimson, Paul Marsh and Mike Staunton, Triumph of the Optimists, Princeton University Press, 2002, and subsequent research.

REAL ANNUALISED RETURNS (%) ON EQUITIES VERSUS BONDS AND BILLS INTERNATIONALLY, 1900–2010

6

5.0 5.5

6.3

7.4

4

2

0

Italy

BelgiumGermanyFrance

SpainIrelandJapan

Norway

Switzerland

Europe (13 country index)

Netherlands

World Excluding USA

Denmark

UK

FinlandWorld

New Zealand

Canada

USA

Sweden

South Africa

Australia

− 2

− 4

Equities

Bonds

Bills

See the concept explained

step by step on the

CourseMate website

SMART

CONCEPTS