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7-1 Over a Century of Capital Market History in One Easy Lesson

162

Part 2 Risk

CHAPTER

7

Introduction to Risk and Return

W

e have managed to go through six chapters without

directly addressing the problem of risk, but now the jig

is up. We can no longer be satisfied with vague statements

like “The opportunity cost of capital depends on the risk of

the project.” We need to know how risk is defined, what the

links are between risk and the opportunity cost of capital,

and how the financial manager can cope with risk in practical

situations.

In this chapter we concentrate on the first of these issues

and leave the other two to Chapters 8 and 9. We start by

summarizing more than 100 years of evidence on rates of

return in capital markets. Then we take a first look at invest-

ment risks and show how they can be reduced by portfolio

diversification. We introduce you to beta, the standard risk

measure for individual securities.

The themes of this chapter, then, are portfolio risk, secu-

rity risk, and diversification. For the most part, we take the

view of the individual investor. But at the end of the chapter

we turn the problem around and ask whether diversification

makes sense as a corporate objective.

Financial analysts are blessed with an enormous quantity of data. There are comprehensive

databases of the prices of U.S. stocks, bonds, options, and commodities, as well as huge

amounts of data for securities in other countries. We focus on a study by Dimson, Marsh, and

Staunton that measures the historical performance of three portfolios of U.S. securities:^1

1. A portfolio of Treasury bills, that is, U.S. government debt securities maturing in less
   than one year.^2


2. A portfolio of U.S. government bonds.


3. A portfolio of U.S. common stocks.
   These investments offer different degrees of risk. Treasury bills are about as safe an invest-
   ment as you can make. There is no risk of default, and their short maturity means that the
   prices of Treasury bills are relatively stable. In fact, an investor who wishes to lend money
   for, say, three months can achieve a perfectly certain payoff by purchasing a Treasury bill

(^1) See E. Dimson, P. R. Marsh, and M. Staunton, Triumph of the Optimists: 101 Years of Investment Returns (Princeton, NJ: Princeton
University Press, 2002).
(^2) Treasury bills were not issued before 1919. Before that date the interest rate used is the commercial paper rate.