CHAPTER
8The Use of Financial Information in the Risk and Return of Equity
I
ndividual investors must be compensated for bearing risk. It seems intu-
itive to the reader that there should be a direct linkage between the risk of
a security and its rate of return. We are interested in securing the maximum
return for a given level of risk, or the minimum risk for a given level of re-
turn. The concept of such risk-return analysis is the efficient frontier of
Harry Markowitz (1952, 1959). If an investor can invest in a government
security, which is backed by the taxing power of the federal government,
then that government security is relatively risk-free. We refer to the 90-day
Treasury bill rate as our risk-free rate. A liquidity premium is paid for
longer-term maturities, due to their increasing risk. Investors are paid inter-
est payments, as determined by the bond’s coupon rate, and may earn price
appreciation. During the period from 1926 to 2003, Treasury bills returned
3.69 percent, longer-term government bonds earned 5.28 percent, corpo-
rate bonds yielded 5.99 percent, and corporate stocks, as measured by the
S&P 500, earned 11.84 percent annually. Small stocks averaged a 16.22
percent return, annually, over the corresponding period. The annualized
standard deviations are 1.00, 19.48, and 29.66 percent, respectively, for
Treasury bills, stocks (S&P), and small stocks. The risk-return trade-off has
been relevant for the 1926–2003 period. Why do corporate stocks offer in-
vestors such returns? Let us review some of the empirical relationships of
risk and return of stocks.
First, as a stockholder, one owns a fraction, a very small fraction for
many investors, of the firm. When one owns stocks, one is paid a divi-
dend and earn stock price appreciation. That is, one buys a stock when
one expects its stock price to raise and compensate one for bearing the
risk of the stock’s price movements. Investors have become aware in re-
cent years that not all price movements are in positive directions. Let us
examine three widely held R&D-intensive stocks: Johnson & Johnson