What is the key lesson from capital market history
Higher risk -> higher expected return (rsk-return trade-off)
What often happens after major market crashes
Strong recoveries (markets tend to rebound)
What is total percentage return
Dividend yield + capital gains yield
Why are percentage returns preferred over dollar returns
Easier to compare investments
Why are financial markets important
- allow saving and investing
- help allocate capital
- provide info about risk and return
What is a risk premium
Extra return earned above the risk-free rate
What is considered the risk-free rate
Treasury bills (T-bills)
Why do different assets have different returns
Because they have different levels of risk
What is the equity risk premium
Extra return of stocks over risk-free assets
Typical long-run equity risk premium
3-7%
What does variance mesure
How spread out returns are (risk)
What does standard deviation measure
Volatility (risk) of returns
Relationship: risk and standard deviation
Higher standard deviation = higher risk
What is a normal distribution
Bell-shaped distribution of returns
Key normal distribution rule
68% within 1 SD
95% within 2 SD
99.7% within 3 SD
What is arithmetic average return
Average return per period
When is the arithmetic average used
For estimating future returns (forward-looking)
What is the geometric average return
Average compounded return over time
When is the geometric average used
For past performances (historical returns)
Why is geometric return lower than arithmetic
Because it accounts for compounding
Is arithmetic or geometric average better for long-term analysis and which is better for short-term forecasts
Geometric average - long-term
Arithmetic average - short-term
Key issues with arithmetic vs geometric
Arithmetic - too high in long-term
Geometric - too low in short-term
Best practical approach to use when unsure
Use a value between arithmetic and geometric averages
Geometric average return can be seen as the same thing as: (bc it accounts for compounding)
The effective rate, bc it accounts for compounding
