Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

V. Risk and Return 12. Some Lessons from

Capital Market History

(^410) © The McGraw−Hill
Companies, 2002

CHAPTER

12

Some Lessons from Capital

Market History

With the Nasdaq stock marketindex down almost 40 percent, 2000 was not a

good year overall for stock market investors, particularly those who

concentrated on technology stocks. In fact, it was an especially bad year for

companies such as Yahoo!, which lost almost 90 percent of its value. Of course,

some stocks do well even in a bad year. Juniper Networks gained 122.5

percent, and OSI Pharmaceuticals was up by an amazing 909.4 percent! These

examples illustrate that there were tremendous potential profits to be made

during 2000, but there was also the risk of losing money, and lots of it. So what

should you, as a stock market investor, expect when you invest your own

money? In this chapter, we study more than seven decades of market history to

find out.

hus far, we haven’t had much to say about what determines the required return on

an investment. In one sense, the answer is very simple: The required return de-

pends on the risk of the investment. The greater the risk, the greater is the required

return.

Having said this, we are left with a somewhat more difficult problem. How can we

measure the amount of risk present in an investment? Put another way, what does it

mean to say that one investment is riskier than another? Obviously, we need to define

what we mean by risk if we are going to answer these questions. This is our task in the

next two chapters.

From the last several chapters, we know that one of the responsibilities of the finan-

cial manager is to assess the value of proposed real asset investments. In doing this, it is

important that we first look at what financial investments have to offer. At a minimum,

the return we require from a proposed nonfinancial investment must be greater than

what we can get by buying financial assets of similar risk.

Our goal in this chapter is to provide a perspective on what capital market history can

tell us about risk and return. The most important thing to get out of this chapter is a feel

for the numbers. What is a high return? What is a low one? More generally, what returns

should we expect from financial assets and what are the risks of such investments? This

perspective is essential for understanding how to analyze and value risky investment

projects.

T

The number of web sites

devoted to financial

markets and instruments

is astounding, and

increasing daily. Be sure

to check out the RWJ web

page for links to

finance-related sites!

(www.mhhe.com/rwj)

381