Chapter 12 – Some Lessons from Capital Market History
Chapter 12
SOME LESSONS FROM CAPITAL MARKET HISTORY
CHAPTER WEB SITES
Section
Web Address
CHAPTER ORGANIZATION
12.1 Returns
12.2 The Historical Record
12.3 Average Returns: The First Lesson
12.4 The Variability of Returns: The Second Lesson
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12.5 More about Average Returns
12.6 Capital Market Efficiency
12.7 Summary and Conclusions
ANNOTATED CHAPTER OUTLINE
12.1. Returns
A. Dollar Returns
Lecture Tip: The issues discussed in this section need to be
B. Percentage Returns
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12.2. The Historical Record
The following are the basis for the nominal pretax rates of return reported by
Ibbotson and Sinquefield and presented in the figures throughout the chapter:
A. A First Look
B. A Closer Look
12.3. Average Returns: The First Lesson
A. Calculating Average Returns
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Lecture Tip: Some students may not recall their statistics, so a
B. Average Returns: The Historical Record
Lecture Tip: Suppose some risk-averse student asks what the worst
C. Risk Premiums
Using the T-bill rate as the risk-free return and aggregate common
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D. The First Lesson
12.4. The Variability of Returns: The Second Lesson
A. Frequency Distributions and Variability
B. The Historical Variance and Standard Deviation
Lecture Tip: Occasionally, students ask why we include the above-
In Portfolio Selection (1959), Harry Markowitz states:
“Analyses based on [semivariance] tend to produce
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C. The Historical Record
D. Normal Distribution
Historical returns on securities have probability distributions that
E. The Second Lesson
F. 2008: The Bear Growled and Investors Howled
G. Using Capital Market History
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Lecture Tip: It is sometimes difficult to get students to appreciate
H. More on the Stock Market Risk Premium
12.5. More about Average Returns
A. Arithmetic versus Geometric Averages
B. Calculating Geometric Average Returns
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C. Arithmetic Average Return or Geometric Average Return?
The geometric average tells you the return you earned per year
12.6. Capital Market Efficiency
Efficient capital market – market in which current market prices fully reflect
available information. In such a market, it is not possible to devise trading
rules that consistently “beat the market” after taking risk into account.
A. Price Behavior in an Efficient Market
Lecture Tip: Is the degree of market efficiency increasing?
Consider the following:
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What does all of this mean? An efficient market is one in which
information is quickly and costlessly disseminated to all
B. The Efficient Markets Hypothesis
Efficient markets hypothesis (EMH) – modern U.S. stock markets
C. Some Common Misconceptions about the EMH
Market efficiency does NOT imply that it doesn’t make a
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Lecture tip: Although a full-blown discussion of efficient markets
goes beyond the scope of the typical introductory corporate
Lecture tip: Claims of superior performance in stock picking are
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The t-stat is .67, which is much less than that required at the 5
percent level of significance. Therefore, Mick’s performance is not
good enough to be declared “superior” based on the distribution
of returns.
Ethics Note: Program trading is defined as automated trading
Program trading can affect market prices. For example, a large,
erroneously executed sell order (which was literally a clerical
error) on March 25, 1992 resulted in a 12-point loss in the DJIA (a
.31% drop in value at that time). This trade occurred during the
Lecture Tip: Even the experts get confused about the meaning of
D. The Forms of Market Efficiency
Strong form efficiency – All information, both public and private,
is already incorporated in the price. Empirical evidence indicates
that this form of efficiency does NOT hold.
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Ethics Note: Insider trading is illegal, but the determination of
what constitutes insider trading is difficult. Rule 10B-5 of the
Chapter 12 – Some Lessons from Capital Market History
Evidence of this can be found in the high profile trial of Martha
Stewart. The gist of the case was that Martha’s friend and CEO of
Imclone told her that an important drug had not received approval
prior to the public announcement. Martha proceeded to sell her
stock in Imclone. Martha was not convicted of insider trading
however. She was convicted of obstructing justice and received a
relatively light sentence of 5 months in prison, 5 months of house
arrest, and 2 years of probation.
Ethics Note: Not all forms of insider trading are illegal. On
12.7. Summary and Conclusions