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THE HISTORICAL RECORD

The historical returns of stock or bond market indexes can give us an idea of the typical performance of different investments. One popular source of such information is an ongoing study by Ibbotson Associates which reports the performance of several portfolios of securities since 1926. These include

1. A portfolio of 3-month loans issued each week by the U.S. government. These loans are known as Treasury bills.

2. A portfolio of long-term Treasury bonds issued by the U.S. government and maturing in about 20 years.

3. A portfolio of stocks of the 500 large firms that make up the Standard & Poor s

Composite Index.

These portfolios are not equally risky. Treasury bills are about as safe an investment as you can make. Because they are issued by the U.S. government, you can be sure that you will get your money back. Their short-term maturity means that their prices are relatively stable. In fact, investors who wish to lend money for 3 months can achieve a certain payoff by buying 3-month Treasury bills. Of course, they can t be sure what that money will buy; there is still some uncertainty about inflation.

Long-term Treasury bonds are also certain to be repaid when they mature, but the prices of these bonds fluctuate more as interest rates vary. When interest rates fall, the value of long-term bonds rises; when rates rise, the value of the bonds falls.

Common stocks are the riskiest of the three groups of securities. When you invest in common stocks, there is no promise that you will get your money back. As a part-owner of the corporation, you receive whatever is left over after the bonds and any other debts have been repaid.

Figure 3.13 illustrates the investment performance of stocks, bonds, and bills since 1926. The figure shows how much one dollar invested at the start of 1926 would have grown to by the end of 1998 assuming that all dividend or interest income had been reinvested in the portfolio.

You can see that the performance of the portfolios fits our intuitive risk ranking. Common stocks were the riskiest investment but they also offered the greatest gains. One dollar invested in 1926 in a portfolio of the S&P 500 stocks would have grown to $2,351 by 1998. At the other end of the spectrum, an investment of $1 in a Treasury bill would have accumulated to only $14.94.

Ibbotson Associates has calculated rates of return for each of these portfolios for each year from 1926 to 1998. These rates of return are comparable to the figure that we calculated for General Electric. In other words, they include (1) dividends or interest and (2) any capital gains or losses. The averages of the 73 rates of return are shown in

Table 3.9.

The safest investment, Treasury bills, had the lowest rates of return they averaged 3.8 percent a year. Long-term government bonds gave slightly higher returns than Treasury bills. This difference is called the maturity premium. Common stocks were in a class by themselves. Investors who accepted the risk of common stocks received on average an extra return of just under 9.4 percent a year over the return on treasury bills. This compensation for taking on the risk of common stock ownership is known as the

market risk premium:

Rate of return = interest rate on + market risk on common stocks Treasury bills premium

The historical record shows that investors have received a risk premium for holding risky assets.Average returns on high-risk assets are higher than those on low-risk assets.

You may ask why we look back over such a long period to measure average rates of return. The reason is that annual rates of return for common stocks fluctuate so much that averages taken over short periods are extremely unreliable. In some years investors in common stocks had a disagreeable shock and received a substantially lower return than they expected. In other years they had a pleasant surprise and received a higherthan- expected return. By averaging the returns across both the rough years and the smooth, we should get a fair idea of the typical return that investors might justifiably expect.

While common stocks have offered the highest average returns, they have also been riskier investments. Figure 3.14 shows the 73 annual rates of return for the three portfolios. The fluctuations in year-to-year returns on common stocks are remarkably wide. There were two years (1933 and 1954) when investors earned a return of more than 50 percent. However, Figure 3.14 shows that you can also lose money by investing in the

stock market. The most dramatic case was the stock market crash of 1929 1932.

Shortly after President Coolidge joyfully observed that stocks were cheap at current prices, stocks rapidly became even cheaper. By July 1932 the Dow Jones Industrial Average had fallen in a series of slides by 89 percent.

Another major market crash, that of Monday, October 19, 1987, does not show up in Figure 3.14. On that day stock prices fell by 23 percent, their largest one-day fall in history. However, Black Monday came after a prolonged rise in stock prices, so that over

1987 as a whole investors in common stocks earned a return of 5.2 percent. This was not a terrible return, but many investors who rode the 1987 roller coaster feel that it is not a year they would care to repeat.

1 This network of traders comprises the over-the-counter market. The computer network and price quotation system is called the NASDAQ system. NASDAQ stands for the National Association of Security Dealers Automated Quotation system.

2 Stock market indexes record the market value of the portfolio. To calculate the total return on the portfolio we would also need to add in any dividends that are paid.

MATURITY PREMIUM Extra average return from investing in long- versus short-term Treasury securities.

RISK PREMIUM Expected return in excess of risk-free return as compensation for risk.