Page 431

PART 5
Risk and Return

CHAPTER 12
Lessons from Capital Market History

Lester69 | [Link]

With the global financial crisis and economic slowdown, the annual return for the S&P/TSX
Composite in 2008 was −33.00%, the index’s worst return in decades. In the recovery period, the
S&P/TSX posted impressive returns of 34.35% in 2009 and 17.25% in 2011. In 2016 the election of
U.S. President Trump seemed to ignite the animal spirits of investors and oil rebounded from about
$30 to over $50. The S&P/TSX returned 21.08%. In early 2020, amid the global stock market crash
triggered by the COVID-19 pandemic, the S&P/TSX dropped by 33.58% from mid-February to mid-
March. However, the index later experienced a rapid recovery, leading to a 1.15% return for the whole
year.

LEARNING OBJECTIVES

After studying this chapter, you should understand:

 LO How to calculate the return on an investment.

LO The historical returns on various important types of investments.

LO The historical risks on various important types of investments.

LO The implications of market efficiency.

Thus 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 depends on the risk of the investment. The greater the risk is, 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.
Page 432

From the last several chapters, we know that one of the responsibilities of the financial manager is to assess the value
of proposed real asset investments. In doing this, it is important to know what financial investments have to offer.
Going further, we saw in Chapter 2 that the cash flow of a firm equals the cash flow to creditors and shareholders.
So the returns and risks of financial investments provide information on the real investments firms undertake.
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 from such
investments? This perspective is essential for understanding how to analyze and value risky investment projects.
We start our discussion on risk and return by describing the historical experience of investors in Canadian financial
markets. In 1931, for example, the stock market lost about 33% of its value. Just two years later, the stock market
gained 51%. In more recent memory, the U.S. market lost about 21% of its value in 2008, while the Canadian market
lost about 33%, and then gained around 34% in 2009. What lessons, if any, can financial managers learn from such
shifts in the stock market? We explore the last half-century of market history to find out.
Not everyone agrees on the value of studying history. On one hand, there is philosopher George Santayana’s famous
comment, “Those who cannot remember the past are condemned to repeat it.” On the other hand, there is
industrialist Henry Ford’s equally famous comment, “History is more or less bunk.” Nonetheless, based on recent
events, perhaps everyone would agree with Mark Twain when he observed, “October. This is one of the peculiarly
dangerous months to speculate in stocks in. The others are July, January, September, April, November, May, March,
June, December, August, and February.”
Two central lessons emerge from our study of market history. First, there is a reward for bearing risk. Second, the
greater the risk, the greater the potential reward. To understand these facts about market returns, we devote much of
this chapter to reporting the statistics and numbers that make up modern capital market history in Canada. Canadians
also invest in the U.S., so we include some discussion of U.S. markets. In the next chapter, these facts provide the
foundation for our study of how financial markets put a price on risk.
 LO1 12.1 | Returns
We wish to discuss historical returns on different types of financial assets. We do this after briefly discussing
how to calculate the return from investing.

Dollar Returns
If you buy an asset of any sort, your gain (or loss) from that investment is called the return on your
investment. This return usually has two components. First, you may receive some cash directly while you
own the investment. This is called the income component of your return. Second, the value of the asset you
purchase often changes over time. In this case, you have a capital gain (or capital loss) on your investment.
1

To illustrate, suppose Canadian Atlantic Enterprises has several thousand shares of stock outstanding. You
purchased some of these shares at the beginning of the year. It is now year-end, and you want to find out
how well you have done on your investment.
Over the year, a company may pay cash dividends to its shareholders. As a shareholder in Canadian Atlantic
Enterprises, you are a part owner of the company. If the company is profitable, it may choose to distribute
some of its profits to shareholders (we discuss the details of dividend policy in Chapter 17). So, as the
owner of some stock, you receive some cash. This cash is the income component from owning the stock.
Page 433

In addition to the dividend, the other part of your return is the capital gain or capital loss on the stock. This
part arises from changes in the value of your investment. For example, consider the cash flows illustrated in
Figure 12.1. The stock is selling for $37 per share. If you buy 100 shares, you have a total outlay of
$3,700. Suppose that, over the year, the stock paid a dividend of $1.85 per share. By the end of the year,
then, you would have received income of:
FIGURE 12.1
Dollar returns
 Dividend = $1.85 × 100 = $185

Also, the value of the stock rises to $40.33 per share by the end of the year. Your 100 shares are worth
$4,033, so you have a capital gain of:
Capital gain = ($40.33 − $37) × 100 = $333

On the other hand, if the price had dropped to, say, $34.78, you would have a capital loss of:
Capital loss = ($34.78 − $37) × 100 = −$222

The total dollar return on your investment is the sum of the dividend and the capital gain:

Total dollar return = Dividend income + Capital gain ( or loss) [12.1]

In our first example, the total dollar return is:

Total dollar return = $185 + 333 = $518

If you sold the stock at the end of the year, the total amount of cash you would have would be your initial
investment plus the total return. From the preceding example:

Total cash if stock is sold = Initial investment + Total return [12.2]

= $3,700 + 518 = $4,218

As a check, notice that this is the same as the proceeds from the sale of the stock plus the dividends:
Proceeds f rom stock sale + Dividends = ($40.33 × 100) + $185

= $4,033 + 185 = $4,218

Suppose you hold on to your Canadian Atlantic stock and don’t sell it at the end of the year. Should you
still consider the capital gain as part of your return? Isn’t this only a paper gain and not really a cash flow if
you don’t sell it?
The answer to the first question is a strong yes, and the answer to the second is an equally strong no. The
capital gain is every bit as much a part of your return as the dividend, and you should certainly count it as
part of your return. The decision to keep the stock and not sell (you don’t realize the gain) is irrelevant
because you could have converted it to cash if you wanted to; whether you choose to or not is up to you.
Page 434

After all, if you insisted on converting your gain to cash, you could always sell the stock at year-end and
immediately reinvest by buying the stock back. There is no net difference between doing this and just not
selling (neglecting transaction costs and assuming there are no tax consequences from selling the stock).
Again, the point is that whether you actually cash out or reinvest by not selling doesn’t affect the return you
earn.

Percentage Returns
It is usually more convenient to summarize information about returns in percentage terms, rather than dollar
terms. The question we want to answer is, how much do we get for each dollar we invest?
To answer this question, let Pt be the price of the stock at the beginning of the year and let D t be the
dividend paid on the stock during the year. Consider the cash flows in Figure 12.2. These are the same as
those in Figure 12.1, except we have now expressed everything on a per-share basis.
FIGURE 12.2
P ercentage, dollar, and per-share returns

In our example, the price at the beginning of the year was $37 per share and the dividend paid during the
year on each share was $1.85. As we discussed in Chapter 8, expressing the dividend as a percentage of
the beginning stock price results in the dividend yield:
 Dt
Dividend yield =
Pt

$1.85
= = .05 = 5%
$37

Essentially, what this means is, for each dollar we invest, we get 5 cents in dividends.
Page 435

The other component of our percentage return is the capital gains yield. This is calculated as the change in
the price during the year (the capital gain) divided by the beginning price:
(P t+1 − P t )
Capital gains yield =
Pt

($40.33 − 37)
= =. 09 = 9%
$37

So, per dollar invested, we get 9 cents in capital gains.

Putting it together, per dollar invested, we get 5 cents in dividends and 9 cents in capital gains for a total of
14 cents. Our percentage return is 14 cents on the dollar, or 14%.
To check this, notice that you invested $3,700 and ended with $4,218. By what percentage did your $3,700
increase? As we saw, you picked up $4,218 − 3,700 = $518. This is a $518/$3,700 = 14% increase.

XAMPLE 12.1
Calculating Returns
Suppose you buy some stock for $25 per share. At the end of the year, the price is $35
per share. During the year, you got a $2 dividend per share. This is the situation illustrated
in Figure 12.3. What is the dividend yield? The capital gains yield? The percentage
return? If your total investment was $1,000, how much do you have at the end of the year?
FIGURE 12.3
Cash flow—an investment example
 Your $2 dividend per share works out to a dividend yield of:
Dt
Dividend yield =
Pt

$2
= = .08 = 8%
$25

The per share capital gain is $10, so the capital gains yield is:
(P t+1 − P t )
Capital gains yield =
Pt

($35 − 25)
= =. 4 = 40%
$25

The total percentage return is thus 8 + 40 = 48% .

If you had invested $1,000, you would have 1.48 × $1,000 = $1,480 at the end of the year,
a 48% increase. To check this, note that your $1,000 would have bought you
$1,000/25 = 40 share. Your 40 shares would then have paid you a total of 40 × $2 = $80

in cash dividends. Your $10 per share gain would give you a total capital gain of
$10 × 40 = $400. Add these together, and you get the $480 total return.

Page 436

To give another example, stock in Air Canada Inc. began 2019 at $25.49 per share. Air Canada did not pay
any dividends in 2019, and the stock price at the end of the year was $48.85. What was the return for the
year? For practice, see if you agree that the answer is 91.64%. Of course, negative returns occur as well. For
example, again in 2019, Baytex Energy Corp. had a stock price of $2.31 per share at the beginning of the
year. No dividends were paid during the year and the stock ended the year at $1.91 per share. Verify that the
loss was 17.32% for the year.

Concept Questions
. What are the two parts of total return?
. Why are unrealized capital gains or losses included in the calculation of returns?
. What is the difference between a dollar return and a percentage return? Why are
percentage returns more convenient?
 LO2 12.2 | The Historical Record
Capital market history is of great interest to investment consultants who advise institutional investors on
portfolio strategy. The data set we use in the following discussion is in Table 12.1. It is based on data
originally assembled by Mercer Investment Consulting, drawing on two major studies. Roger Ibbotson and
Rex Sinquefield conducted a famous set of studies dealing with rates of return in U.S. financial markets.
James Hatch and Robert White examined Canadian returns. 2 Our data presents year-to-year historical rates
of return on six important types of financial investments. The returns can be interpreted as what you would
have earned if you held portfolios of the following:
1. Canadian common stocks. The common stock portfolio is based on a sample of the largest companies
(in total market value of outstanding stock) in Canada. 3
2. U.S. common stocks. The U.S. common stock portfolio consists of 500 of the largest U.S. companies.
This series presents U.S. stock returns in Canadian dollars adjusting for shifts in exchange rates.
3. TSX Venture stock. The TSX Venture stock portfolio consists of small and emerging companies that do
not yet meet listing requirements for the S&P/TSX Composite Index.
4. Small stocks. The small stock portfolio is composed of the small-capitalization Canadian stocks as
compiled by BMO Nesbitt Burns.
5. Long bonds. The long bond portfolio has high-quality, long-term corporate, provincial, and Government
of Canada bonds.
6. Canada Treasury bills. The T-bill portfolio has Treasury bills with a three-month maturity.

These returns are not adjusted for inflation or taxes; thus, they are nominal, pre-tax returns.
Page 437

Page 438

TABLE 12.1

Annual market index returns, 1948–2019

Canadian Stocks FTSE TMX Long S

Statistics S&P /TSX FTSE TMX Canada long- US stocks S&P Nesbitt Burns V
Year Canada Infl ation Composite Canada 91-day T-bill* term bond ** 500 (Cdn. $ ) small stocks Co
1948 8.88 12.25 0.40 −0.80 5.50
1949 1.09 23.85 0.45 5.18 22.15
1950 5.91 51.69 0.51 1.74 39.18
1951 10.66 25.44 0.71 −7.89 15.00
1952 −1.38 0.01 0.95 5.01 13.68
1953 0.00 2.56 1.54 5.00 −0.99
1954 0.00 39.37 1.62 12.23 52.62
1955 0.47 27.68 1.22 0.13 35.51
1956 3.24 12.68 2.63 −8.87 2.35
 Canadian Stocks FTSE TMX Long S
Statistics S&P /TSX FTSE TMX Canada long- US stocks S&P Nesbitt Burns V
Year Canada Infl ation Composite Canada 91-day T-bill* term bond ** 500 (Cdn. $ ) small stocks Co
1957 1.79 −20.58 3.76 7.94 −8.51
1958 2.64 31.25 2.27 1.92 40.49
1959 1.29 4.59 4.39 −5.07 10.54
1960 1.27 1.78 3.66 12.19 5.15
1961 0.42 32.75 2.86 9.16 32.85
1962 1.67 −7.09 3.81 5.03 −5.77
1963 1.64 15.60 3.58 4.58 23.19
1964 2.02 25.43 3.73 6.16 15.75
1965 3.16 6.67 3.79 0.05 12.58
1966 3.45 −7.07 4.89 −1.05 −9.33
1967 4.07 18.09 4.38 −0.48 23.61
1968 3.91 22.45 6.22 2.14 10.26
1969 4.79 −0.81 6.83 −2.86 −8.50
1970 1.31 −3.57 6.89 16.39 −1.96 −11.69
1971 5.16 8.01 3.86 14.84 13.28 15.83
1972 4.91 27.37 3.43 8.11 18.12 44.72
1973 9.36 0.27 4.78 1.97 −14.58 −7.82
1974 12.30 −25.93 7.68 −4.53 −26.87 −26.89
1975 9.52 18.48 7.05 8.02 40.72 41.00
1976 5.87 11.02 9.10 23.64 22.97 22.77
1977 9.45 10.71 7.64 9.04 0.65 39.93
1978 8.44 29.72 7.90 4.10 15.50 44.41
1979 9.69 44.77 11.01 −2.83 16.52 46.04
1980 11.20 30.13 12.23 2.18 35.51 42.86
1981 12.20 −10.25 19.11 −2.09 −5.57 −15.10
1982 9.23 5.54 15.27 45.82 25.84 4.55 P
43
1983 4.51 35.49 9.39 9.61 24.07 44.30
1984 3.77 −2.39 11.21 16.90 12.87 −2.33
1985 4.38 25.07 9.70 26.68 39.82 38.98
1986 4.19 8.95 9.34 17.21 16.96 12.33
1987 4.12 5.88 8.20 1.77 −0.96 −5.47
1988 3.96 11.08 8.94 11.30 7.21 5.46
1989 5.17 21.37 11.95 15.17 27.74 10.66
1990 5.00 −14.80 13.28 4.32 −3.06 −27.32
1991 3.78 12.02 9.90 25.30 30.05 18.51
1992 2.14 −1.43 6.65 11.57 18.42 13.01
1993 1.70 32.55 5.63 22.09 14.40 52.26
1994 0.23 −0.18 4.76 −7.39 7.48 −9.21
 Canadian Stocks FTSE TMX Long S
Statistics S&P /TSX FTSE TMX Canada long- US stocks S&P Nesbitt Burns V
Year Canada Infl ation Composite Canada 91-day T-bill* term bond ** 500 (Cdn. $ ) small stocks Co
1995 1.75 14.53 7.39 26.34 33.68 13.88
1996 2.17 28.35 5.02 14.18 23.62 28.66
1997 0.73 14.98 3.20 18.46 39.18 6.97
1998 1.02 −1.58 4.74 12.85 37.71 −17.90
1999 2.58 31.59 4.66 −5.98 14.14 20.29
2000 3.23 7.41 5.49 12.97 −5.67 −4.29
2001 0.60 −12.60 4.70 8.10 −6.50 0.70
2002 4.30 −12.40 2.50 8.70 −22.70 −0.90
2003 1.60 26.70 2.90 6.70 5.30 42.70
2004 2.40 14.50 2.30 7.20 3.30 14.10
2005 2.00 23.29 2.58 6.46 3.80 13.70
2006 1.60 17.30 4.00 4.10 15.70 20.83
2007 2.10 9.80 4.40 3.70 −10.50 −11.38
2008 1.20 −33.00 3.30 2.70 −21.20 −46.60
2009 1.30 34.35 0.60 5.31 9.26 86.80
2010 2.40 17.27 0.50 12.10 8.10 36.10
2011 2.30 −8.57 1.00 17.72 4.39 −19.50
2012 1.50 5.41 1.00 5.20 10.98 −1.19
2013 0.90 9.55 1.00 −6.20 38.45 4.48
2014 2.00 7.42 0.90 17.50 21.74 −2.67
2015 1.10 −8.32 0.63 3.80 21.59 –13.75 –
2016 1.40 21.08 0.51 2.47 8.09 35.39
2017 1.60 9.10 0.66 7.03 13.83 6.38
2018 2.30 -8.88 1.38 0.22 3.54 -18.20
2019 1.95 22.88 1.66 12.53 28.06 15.80
Source s: Ba se d on da ta from Sta tistics Ca na da a nd S&P Dow Jone s Indice s (a cce sse d Se pte mbe r 30, 2020); Glo b e and Mail (a cce sse d Octobe r 2, 2020).

Page 439

In addition to the year-to-year returns on these financial instruments, the year-to-year percentage change in
the Statistics Canada Consumer Price Index (CPI) is also computed. This is a commonly used measure of
inflation, so we can calculate real returns using this as the inflation rate.

The six asset classes included in Table 12.1 cover a broad range of investments popular with Canadian
individuals and financial institutions. We include U.S. stocks since Canadian investors often invest abroad—
particularly in the United States. 4

A First Look
Before looking closely at the different portfolio returns, we take a look at the big picture. Figure 12.4
shows what happened to $1 invested in three of these different portfolios at the beginning of 1957. We work
with a sample period of 1957–2019 for two reasons; the years immediately after the Second World War do
not reflect trends today and the TSE 300 (predecessor of the TSX) was introduced in 1956, making 1957
the first really comparable year. This decision is somewhat controversial and we return to it later as we draw
lessons from our data. The growth in value for each of the different portfolios over the 63-year period
ending in 2019 is given separately. Notice that, to get everything on a single graph, some modification in
scaling is used. As is commonly done with financial series, the vertical axis is on a logarithmic scale such
that equal distances measure equal percentage changes (as opposed to equal dollar changes) in value.
FIGURE 12.4
Returns to a $ 1 inv estment, 1957–2019

Sources: Based on data from Bank of Canada (CPI Index); TMX Group (Canadian stocks); and FTSE (Long Bond and T-Bill Indices).

Page 440

Looking at Figure 12.4, we see that the common stock investments did the best overall. Every dollar
invested in Canadian stocks grew to $180.41 over the 63 years.
At the other end, the T-bill portfolio grew to only $27.01. Long bonds did better with an ending value of
$107.51. These values are less impressive when we consider inflation over this period. As illustrated, the
price level climbed such that $8.92 is needed just to replace the original $1.
Given the historical record as discussed so far, why would any investor hold any asset class other than
common stocks? A close look at Figure 12.4 provides an answer. The T-bill portfolio and the long-term
bond portfolio grew more slowly than did the stock portfolio, but they also grew much more steadily. The
common stocks ended up on top but, as you can see, they grew erratically at times. For example,
comparing Canadian stocks with T-bills, the stocks had a smaller return in 23 of the 63 years examined, as
you can see in Table 12.1.

A Closer Look
To illustrate the variability of the different investments, we look at a few selected years in Table 12.1. For
example, looking at long-term bonds, we see the largest historical return (45.82%) occurred in 1982. This
was a good year for bonds. The largest single-year return in the table is a very healthy 90.80% for the
S&P/TSX Venture Composite in 2009. In the same year, T-bills returned only 0.60%. In contrast, the
largest Treasury bill return was 19.11% (in 1981).

Concept Questions
. With 20:20 hindsight, what was the best investment for the period 1981–82?
. Why doesn’t everyone just buy common stocks as investments?
. What was the smallest return observed over the 63 years for each of these investments?
When did it occur?
. How many times did large Canadian stocks (common stocks) return more than 30%? How
many times did they return less than 20%?
. What was the longest winning streak (years without a negative return) for large Canadian
stocks? For long-term bonds?
. How often did the T-bill portfolio have a negative return?
. How have Canadian stocks compared with U.S. stocks over the last ten years?
 LO2 12.3 | Average Returns: The First Lesson
As you’ve probably begun to notice, the history of capital market returns is too complicated to be of much
use in its undigested form. We need to begin summarizing all these numbers. Accordingly, we discuss how
to consider the detailed data. We start by calculating average returns.
Page 441

Calculating Average Returns

The obvious way to calculate the average returns from 1957–2019 on the different investments in
Table 12.1 is simply to add up the yearly returns and divide by 63. The result is the historical average of
the individual values. Statisticians call this the arithmetic average or arithmetic mean return. It has the
advantage of being easy to calculate and interpret, so we use it here to measure expected return.
For example, if you add the returns for the Canadian common stocks for the 63 years, you get about
633.10. The average annual return is thus 633 .10 /63 = 10.05% . You interpret this 10.05% just like any
other average. If you picked a year at random from the 63-year history and you had to guess what the return
in that year was, the best guess is 10.05%.

Average Returns: The Historical Record

Table 12.2 shows the average returns computed from Table 12.1. As shown, in a typical year, the
small stocks increased in value by 12.04%. Notice also how much larger the stock returns are than the
bond returns.

TABLE 12.2

Average annual returns, 1957–2019

Inv estment Arithmetic Av erage Return (% )

Canadian common stocks 10.05
U.S. common stocks (Cdn $) 11.99
Long bonds 8.30
Small stocks 12.04
TSX Venture stocks 5.25
Inflation 3.65
Treasury bills 5.49

These averages are, of course, nominal since we haven’t worried about inflation. Notice that the average
inflation rate was 3.65% per year over this 63-year span. The nominal return on Canada Treasury bills was
5.49% per year. The average real return on Treasury bills was thus approximately 1.84% per year; so the real
return on T-bills has been quite low historically.
At the other extreme, Canadian common stocks had an average real return of about
10.05% − 3.65% = 6.40% , which is relatively large. If you remember the Rule of 72 ( Chapter 5),
then a quick “back-of-the-envelope” calculation tells us that 6.40% real growth doubles your buying power
about every 11.25 years.
The TSX Venture stocks show an average return of 5.25%, which is lower than the return on T-bills. 5 Since
venture stocks fluctuate greatly (as seen in Table 12.1), averages taken over short periods are considered
extremely unreliable.
Page 442

Risk Premiums
Now that we have computed some average returns, it seems logical to see how they compare with each
other. Based on our discussion so far, one such comparison involves government-issued securities. These
are free of much of the variability we see in, for example, the stock market.
The Government of Canada borrows money by issuing debt securities in different forms. The ones we focus
on are Treasury bills. These have the shortest time to maturity of the different government securities.
Because the government can always raise taxes to pay its bills, this debt is virtually free of any default risk
over its short life. Thus, we call the rate on such debt the risk-free return, and we use it as a benchmark.
A particularly interesting comparison involves the virtually risk-free return on T-bills and the very risky
return on common stocks. The difference between these two returns can be interpreted as a measure of the
excess return on the average risky asset (assuming that the stock of a large Canadian corporation has about
average risk compared to all risky assets).
We call this the excess return because it is the additional return we earn by moving from a relatively risk-free
investment to a risky one. Because it can be interpreted as a reward for bearing risk, we call it a risk premiu
m.

From Table 12.2, we can calculate the risk premiums for the different investments. We report only the
nominal risk premium in Table 12.3 because there is only a slight difference between the historical
nominal and real risk premiums. The risk premium on T-bills is shown as zero in the table because we have
assumed that they are riskless.

TABLE 12.3

Average annual returns and risk premiums, 1957–2019

Inv estment Arithmetic Av erage Return (% ) Risk P remium (% )

Canadian common stocks 10.05 4.56
U.S. common stocks (Cdn $) 11.99 6.50
Long bonds 8.30 2.81
Small stocks 12.04 6.55
TSX Venture stocks 5.25 −0.24
Inflation 3.65 −1.84
Treasury bills 5.49 0.00
Ave ra g e re turns on sma ll stocks a nd TSX Ve nture stocks a re ba se d on da ta from 1970–2019 a nd 2002–2019, re spe ctive ly.

The First Lesson

Looking at Table 12.3, we see that the average risk premium earned by a typical Canadian common
stock is 10.05 − 5.49 = 4.56% . This is a significant reward. The fact that it exists historically is an
important observation, and it is the basis for our first lesson: risky assets, on average, earn a risk premium.
Put another way, there is a reward for bearing risk.
Why is this so? Why, for example, is the risk premium for common stocks larger than the risk premium for
long bonds? More generally, what determines the relative sizes of the risk premiums for the different assets?
The answers to these questions are at the heart of modern finance, and the next chapter is devoted to them.
For now, part of the answer can be found by looking at the historical variability of the returns on these
different investments. So, to get started, we now turn our attention to measuring variability in returns.

Concept Questions
. What do we mean by excess return and risk premium?
. What was the nominal risk premium on long bonds? The real risk premium?
. What is the first lesson from capital market history?
 Page 443

LO3 12.4 | The Variability of Returns: The

Second Lesson
We have already seen that the year-to-year returns on common stocks tend to be more volatile than the
returns on, say, long-term bonds. Next we discuss measuring this variability so we can begin examining the
subject of risk.

Frequency Distributions and Variability

To get started, we can draw a frequency distribution for the Canadian common stock returns as in
Figure 12.5. What we have done here is count the number of times the annual return on the common
stock portfolio falls within each 5% range. For example, in Figure 12.5, the height of 1 in the range
−30% to −25% means that one of the 63 annual returns was in that range.
FIGURE 12.5
Frequency distribution of returns on Canadian common stocks

Sources: Author calculations based on data from Statistics Canada and S&P Dow Jones Indices (accessed September 30, 2020); and Globe and Mail (accessed

October 2, 2020).

Now we need to measure the spread in returns. We know, for example, that the return on Canadian common
stocks in a typical year was 10.05%. We now want to know how far the actual return deviates from this
average in a typical year. In other words, we need a measure of how volatile the return is. The variance and
its square root, the standard deviation, are the most commonly used measures of volatility. We describe
how to calculate them next.
Page 444

The Historical Variance and Standard Deviation

The variance essentially measures the average squared difference between the actual returns and the average
return. The bigger this number is, the more the actual returns tend to differ from the average return. Also,
the larger the variance or standard deviation is, the more spread out the returns are.
The way we calculate the variance and standard deviation depends on the situation. In this chapter, we are
looking at historical returns, so the procedure we describe here is the correct one for calculating the
historical variance and standard deviation. If we were examining projected future returns, the procedure
would be different. We describe that procedure in the next chapter.
To illustrate how we calculate the historical variance, suppose a particular investment had returns of 10%,
12%, 3%, and −9% over the last four years. The average return is (.10 + .12 + .03 − .09)/4 = 4% .
Notice that the return is never actually equal to 4%. Instead, the first return deviates from the average by
.10 − .04 = .06, the second return deviates from the average by .12 − .04 = .08, and so on. To compute

the variance, we square each of these deviations, add them up, and divide the result by the number of returns
less one, or three in this case. This information is summarized in the following table:

(1) Actual Returns (2) Av erage Return (3) Dev iation (1) – (2) (4) Squared Dev iation
.10 .04 .06 .0036
.12 .04 .08 .0064
.03 .04 −.01 .0001
−.09 .04 −.13 .0169
Totals .16 .00 .0270

In the first column, we write down the four actual returns. In the third column, we calculate the difference
between the actual returns and the average by subtracting out 4%. Finally, in the fourth column, we square
the numbers in column 3 to get the squared deviations from the average.
The variance can now be calculated by dividing .0270, the sum of the squared deviations, by the number of
returns less one. Let Var(R) or σ2 (read this as sigma squared) stand for the variance of the return:
. 027
2
Var(R) = σ = = .009
4 − 1

The standard deviation is the square root of the variance. So, if SD(R) or σ stands for the standard deviation
of return:

SD(R) = σ = √ 0.009 = .09487

The square root of the variance is used because the variance is measured in squared percentages and, thus, is
hard to interpret. The standard deviation is an ordinary percentage, so the answer here could be written as
9.487%.
 In the preceding table, notice that the sum of the deviations is equal to zero. This is always the case, and it
provides a good way to check your work. In general, if we have T historical returns, where T is some
number, we can write the historical variance as:

2 2 [12.3]
[(R 1 − R) + … + (R T − R) ]

Var(R) =
T − 1

Page 445

This formula tells us to do just what we did above. Take each of the T individual returns (R1 , R2,…) and
subtract the average return, R ; square the result, and add them up; finally, divide this total by the number of
returns less one (T − 1) because our 63 years’ data represent only a sample, not the full population. The
standard deviation is always the square root of Var(R).
Each of the above calculations can also be completed using an Excel spreadsheet. Once your data are
entered, you can use the following functions:
Average = AVERAGE()

Variance = VAR()

Standard Deviation = STDEV()

XAMPLE 12.2
Calculating the Variance and Standard Deviation
Suppose Northern Radio Comm and the Canadian Empire Bank have experienced the
following returns in the last four years:

Year Northern Radio Comm Returns Canadian Empire Bank Returns

2017 −.20 .05
2018 .50 .09
2019 .30 −.12
2020 .10 .20

What are the average returns? The variances? The standard deviations? Which investment
was more volatile?
To calculate the average returns, we add the returns and divide by four. The results are:
(−0.20 + 0.50 + 0.30 + 0.10) . 70
Northern Radio Comm average return = R = = = .175
4 4

(0.05 + 0.09 − 0.12 + 0.20) .22

Canadian Empire Bank average return = R = = = .055
4 4

To calculate the variance for Northern Radio Comm, we can summarize the relevant
calculations as follows:

Year (1) Actual Returns (2) Av erage Returns (3) Dev iation (1) – (2) (4) Squared Dev iation
2017 −.20 .175 −.375 .140625
 Year (1) Actual Returns (2) Av erage Returns (3) Dev iation (1) – (2) (4) Squared Dev iation
2018 .50 .175 .325 .105625
2019 .30 .175 .125 .015625
2020 .10 .175 −.075 .005625
Totals .70 .000 .267500

Since there are four years of returns, we calculate the variances by dividing .2675 by
(4 − 1) = 3:

Northern Radio Comm Canadian Empire Bank

Variance (σ 2 ) .2675/3 = .0892 .0529/3 = .0176
Standard deviation (σ) √ .0892 = .2987 √ .0176 = .1327

For practice, check that you get the same answer as we do for Canadian Empire Bank.
Notice that the standard deviation for Northern Radio Comm, 29.87%, is a little more than
twice Canadian Empire’s 13.27%; Northern Radio Comm is thus the more volatile
investment.*

Page 446

The Historical Record

Table 12.4 summarizes much of our discussion of capital market history so far. It displays average
returns and standard deviations of annual returns. We used spreadsheet software to calculate these standard
deviations. For example, in Excel it is STDEV. In Table 12.4, notice, for example, that the standard
deviation for the Canadian common stock portfolio (16.32% per year) is about four times as large as the T-
bill portfolio’s standard deviation (3.91% per year). We return to these figures momentarily.

TABLE 12.4

Historical returns and standard deviations, 1957–2019

Inv estment Arithmetic Av erage Return (% ) Standard Dev iation (% )

Canadian common stocks 10.05 16.32
U.S. common stocks (Cdn $) 11.99 16.46
Long bonds 8.30 9.50
Small stocks 12.04 25.49
TSX Venture stocks 5.25 40.40
Inflation 3.65 3.03
Treasury bills 5.49 3.91

Ave ra g e re turns on sma ll stocks a nd TSX Ve nture stocks a re ba se d on da ta from 1970–2019 a nd 2002–2019, re spe ctive ly.

Source s: Author ca lcula tions ba se d on da ta from Sta tistics Ca na da a nd S&P Dow Jone s Indice s (a cce sse d Se pte mbe r 30, 2020); a nd Glo b e and Mail (a cce sse d

Octobe r 2, 2020).
Normal Distribution
For many different random events in nature, a particular frequency distribution, the normal distribution (or
bell curve), is useful for describing the probability of ending up in a given range. For example, the idea
behind grading on a curve comes from the fact that exam scores often resemble a bell curve.

Figure 12.6 illustrates a normal distribution and its distinctive bell shape. As you can see, this
distribution has a much cleaner appearance than the actual return distributions illustrated in Figure 12.5.
Even so, like the normal distribution, the actual distributions do appear to be at least roughly mound-
shaped and symmetrical. When this is true, the normal distribution is often a very good approximation. 6
FIGURE 12.6
The normal distribution. Illustrated returns are based on the historical return and standard dev iation for a portfolio of large common
stocks.

Also, keep in mind that the distributions in Figure 12.5 are based on only 63 yearly observations while
Figure 12.6 is, in principle, based on an infinite number. So, if we had been able to observe returns for,
say, 1,000 years, we might have filled in a lot of the irregularities and ended up with a much smoother
picture. For our purposes, it is enough to observe that the returns are at least roughly normally distributed.
The usefulness of the normal distribution stems from the fact that it is completely described by the average
and standard deviation. If you have these two numbers, there is nothing else to know. For example, with a
normal distribution, the probability that we end up within one standard deviation of the average is about
two-thirds. The probability that we end up within two standard deviations is about 95%. Finally, the
probability of being more than three standard deviations away from the average is less than 1%. These
ranges and the probabilities are illustrated in Figure 12.6.
Page 447

To see why this is useful, recall from Table 12.4 that the standard deviation of returns on Canadian
common stocks is 16.32%. The average return is 10.05%. So, assuming that the frequency distribution is at
least approximately normal, the probability that the return in a given year is in the range −6.27% to 26.37%
(10.05% plus or minus one standard deviation, 16.32%) is about two-thirds. 7 This range is illustrated in
Figure 12.6. In other words, there is about one chance in three that the return is outside the range. This
literally tells you that, if you buy stocks in larger companies, you should expect to be outside this range in
one year out of every three. This reinforces our earlier observations about stock market volatility. However,
there is only a 5% chance (approximately) that we would end up outside the range −22.59% to 42.69%
(10.05% plus or minus 2 × 16.32%, or two standard deviations). These points are also illustrated in
Figure 12.6.

Value at Risk
We can take this one step further to create a measure of risk that is widely used. Suppose you are a risk
management executive at a bank that has $100 million invested in stocks. You want to know how much you
can lose in any one year. We just showed that based on historical data you would be outside the range of
−22.59% to 42.69% only 5% of the time. Because we based this on a normal distribution, you know that the
distribution is symmetric. In other words, the 5% chance of being outside the range breaks down into a
2.5% probability of a return above 42.69% and an equal 2.5% chance of a return below −22.59%. You want
to find out how much you can lose, so you can safely ignore the chance of a return above 42.69%. Instead,
you focus on the 2.5% probability of a loss of more than 22.59% of the portfolio.
Page 448

What you have discovered is that 97.5% of the time, your loss will not exceed this level. On a portfolio of
$100 million, this means that your maximum loss estimate is
$100 million × (−22.59%) = −$22.59 million. This number is called value at risk (VaR). You can

find examples of VaR in the annual report of Bank of Montreal and all other Canadian banks. Since VaR is a
measure of possible loss, financial institutions use it in determining adequate capital levels. Financial
institutions recognize that VaR likely underestimates the amount of capital needed because it is based on
assuming a normal distribution of returns.

Calculator HINTS

Finding Standard Deviation (s) and Mean (x)

(Using Texas Instruments BA II Plus Financial Calculator)
You can solve Example 12.2 using a financial calculator by doing the following:
Clear any previous data:
Action Keystrokes
Select the data entry function of the calculator. [DATA]

Clear any pre-existing data from the worksheet. [CLR WORK]

Enter the data into the calculator.

Keystrokes Calculator Display
−0.20$ X01 = −0.20
 Y01 = 1.00

0.50 X02 = 0.50

Y02 = 1.00

0.30 X03 = 0.30

Y03 = 1.00

0.10 X04 = 0.10

Y04 = 1.00

Before calculating the statistics:

Action Keystroke Calculator Display
Select the statistics calculation function [STAT] Will display any pre-existing data
of the calculator. from prior use
Clear any pre-existing data from the [CLR WORK] LIN
worksheet.
Set the calculator to 1-variable [SET] 1-V
calculation mode.
Repeatedly tap the [SET] key to toggle the
different options.

To view statistics of data set:

Action Keystroke Calculator Display
To view mean (x), toggle downward x = 0.1750

To view sample standard deviation (s), toggle downward Sx = 0.2986

Page 449

The Second Lesson

Our observations concerning the year-to-year variability in returns are the basis for our second lesson from
capital market history. On average, bearing risk is handsomely rewarded, but in a given year, there is a
significant chance of a dramatic change in value. Thus, our second lesson is this: the greater the potential
reward, the greater the risk.

TSX Venture stocks in Table 12.4 illustrate the second lesson over again, as this investment has both the
highest return in a single year (90.8% in 2009) and the largest standard deviation of any Canadian
investment. Moreover, small stocks have the second-largest standard deviation, but also the second-highest
return in a single year (86.8% in 2009).

2008: The Bear Growled and Investors Howled

To reinforce our point concerning stock market volatility, consider that a decade ago, 2008 entered the
record books as one of the worst years for stock market investors in Canadian and global history. How bad
was it? As shown in Table 12.1, the widely followed S&P/TSX Composite plunged 33%.
Over the period 1948–2019, 2008 was the worst year, although 1974 came close with a loss of 25.93%.
Making matters worse, the downdraft continued with a further decline of 17% in early 2009. In all, from
August 2008 (when the decline began in Canada) through March 2009 (when it ended), the S&P/TSX lost
50% of its value.
The drop in stock prices was a global phenomenon with the U.S. S&P 500 also falling by a similar
percentage in U.S. dollar terms. Many of the world’s major markets were off by much more. China, India,
and Russia, for example, all experienced declines of more than 50%. Iceland saw share prices drop by more
than 90% in 2008. Trading on the Icelandic exchange was temporarily suspended on October 9, 2008. In
what has to be a modern record for a single day, stocks fell by 76% when trading resumed on October 14.
Were there any bright spots in the financial crisis? The answer is yes, because as stocks tanked, bonds did
well with returns in Canada of 2.70% in 2008 and 5.31% in 2009. These returns were especially impressive
considering that the rate of inflation was just over 1%.
Of course, stock prices can be volatile in both directions. Starting in March 2009, stock prices climbed
for an overall return of 34.35% in 2009 and a further 17.27% in 2010. So what lessons should investors take
away from this very recent, and very turbulent, bit of capital market history? First, and most obviously,
stocks have significant risk! But there is a second, equally important lesson. Depending on the mix, a
diversified portfolio of stocks and bonds might have suffered in 2008, but the losses would have been much
smaller than those experienced by an all-stock portfolio. In other words, diversification matters, a point we
will examine in detail in our next chapter.

Using Capital Market History

Based on the discussion in this section, you should begin to have an idea of the risks and rewards from
investing. For example, suppose Canada Treasury bills are paying about 5%. Suppose further we have an
investment that we think has about the same risk as a portfolio of large-firm Canadian common stocks. At a
minimum, what return would this investment have to offer to catch our interest?

From Table 12.3, the risk premium on Canadian common stocks has been 4.56% historically, so a
reasonable estimate of our required return would be this premium plus the T-bill rate,
5.0% + 4.56% = 9.56% . This may strike you as low, as during the 1990s, as well as in the years

immediately after the Second World War, double-digit returns on Canadian and U.S. stocks were common,
as Table 12.1 shows. Currently, most financial executives and professional investment managers expect
lower returns and smaller risk premiums in the future. 8
Page 450

We agree with their expectation, and this relates to our earlier discussion of which data to use to calculate
the market risk premium. In Table 12.1 we display returns data back to 1948 but go back to only 1957
when we calculate risk premiums in Table 12.3. This drops off the high returns experienced in many of
the post-war years. If we recalculate the returns and risk premiums in Table 12.3 going all the way back
 to 1948, we arrive at a market risk premium of 6.56%. We think this is too high looking to the future but we
have to recognize that this is a controversial point over which experts disagree.
We discuss the relationship between risk and required return in more detail in the next chapter.

XAMPLE 12.3
Investing in Growth Stocks
The phrase growth stock is frequently a euphemism for small-company stock. Are such
investments suitable for elderly, conservative investors? Before answering, you should
consider the historical volatility. For example, from the historical record, what is the
approximate probability that you could actually lose 10% or more of your money in a single
year if you buy a portfolio of such companies?
Looking back at Table 12.4, the average return on small stocks is 12.04% and the
standard deviation is 25.49%. Assuming the returns are approximately normal, there is
about a one-third probability that you could experience a return outside the range −13.45%
to 37.53% (12.04 plus or minus one standard deviation).
Because the normal distribution is symmetric, the odds of being above or below this range
are equal. There is thus a one-sixth chance (half of one-third) that you could lose more than
13.45%. So you should expect this to happen once in every six years, on average. Such
investments can therefore be very volatile, and they are not well suited for those who
cannot afford the risk.*

Concept Questions
. In words, how do we calculate a variance? A standard deviation?
. With a normal distribution, what is the probability of ending up more than one standard
deviation below the average?
. Assuming that long-term bonds have an approximately normal distribution, what is the
approximate probability of earning 18% or more in a given year? With T-bills, what is this
probability?
. What is the first lesson from capital market history? The second?
 Page 451

LO1 12.5 | More on Average Returns

So far in this chapter, we have looked closely at simple average returns. However, there is another way of
computing an average return. The fact that average returns are calculated two different ways leads to some
confusion, so our goal in this section is to explain the two approaches and also the circumstances under
which each is appropriate.

Arithmetic versus Geometric Averages

Let’s start with a simple example. Suppose you buy a particular stock for $200. Unfortunately, the first year
you own it, it falls to $100. The second year you own it, it rises back to $200, leaving you where you
started (no dividends were paid).
What was your average return on this investment? Common sense seems to say that your average return must
be exactly zero since you started with $200 and ended with $200. But if we calculate the returns year-by-
year, we see that you lost 50% the first year (you lost half of your money) and made 100% the second year
(you doubled your money). Your average return over the two years was thus (−50% + 100%)/2 = 25% !
So which is correct, 0% or 25%? The answer is that both are correct, they just answer different questions.
The 0% is called the geometric average return. The 25% is called the arithmetic average return. The
geometric average return answers the question, “What was your average compound return per year over a
particular period?” While the arithmetic average return answers the question, “What was your return in an
average year over a particular period?”
Notice that, in previous sections, the average returns we calculated were all arithmetic averages, so we
already know how to calculate them. What we need to do now is (1) learn how to calculate geometric
averages and (2) learn the circumstances under which one average is more meaningful than the other.

Calculating Geometric Average Returns

First, to illustrate how we calculate a geometric average return, suppose a particular investment had annual
returns of 10%, 12%, 3%, and −9% over the last four years. The geometric average return over this four-year
period is calculated as:
1/4
(1.10 × 1.12 × 1.03 × .91) − 1 = 3.66%.

In contrast, the average arithmetic return we have been calculating is:

(.10 + .12 + .03 − .09)
= 4.0%.
4

In general, if we have T years of returns, the geometric average return over these T years is calculated using
the following formula:
 1/T
Geometric average return = [(1 + R 1 ) × (1 + R 2 ) × … × (1 + R T )] − 1 [12.4]

This formula tells us that four steps are required:

1. Take each of the T annual returns R1 , R2, …, RT and add a one to each (after converting them to
decimals!).
2. Multiply all the numbers from step 1 together.
3. Take the result from step 2 and raise it to the power of 1/T.
4. Finally, subtract one from the result of step 3. The result is the geometric average return.

Page 452

XAMPLE 12.4
Calculating the Geometric Average Return
Calculate the geometric average return for S&P 500 large-cap stocks for the first five years
in Table 12.1, 1948–1952.
First, convert percentages to decimal returns, add one, and then calculate their product:

S&P 500 Returns P roduct

5.50% 1.055
22.15 × 1.2215
39.18 × 1.3918
15.00 × 1.15
13.68 × 1.1368
2.3448

Notice that the number 2.3448 is what our investment is worth after five years if we started
with a $1 investment. The geometric average return is then calculated as:
1/5
Geometric average return = 2.3448 − 1 = 0.1858 = 18.58%

Thus, the geometric average return is about 18.58% in this example. Here is a tip; if you are
using a financial calculator, you can follow the approach we presented in Chapter 5 and
put $1 in as the present value, $2.3448 as the future value, and five as the number of
periods. Then, solve for the unknown rate. You should get the same answer we did.

One thing you may have noticed in our examples thus far is that the geometric average returns seem to be
smaller than the corresponding arithmetic average. It turns out that this will always be true (as long as the
returns are not all identical, in which case the two “averages” would be the same).

As shown in Table 12.5, the geometric averages are all smaller, but the magnitude of the difference
varies quite a bit. The reason is that the difference is greater for more volatile investments. In fact, there is
useful approximation. Assuming all the numbers are expressed in decimals (as opposed to percentages),
the geometric average return is approximately equal to the arithmetic average return minus half the variance.
For example, looking at the Canadian stocks, the arithmetic average is .1005 and the standard deviation is
 .1632, implying that the variance is .0266. The approximate geometric average is thus
.1005 − (.0266/2) =.0872, which is quite close to the actual value of .0879.

TABLE 12.5

Geometric versus arithmetic average returns, 1957–2019

Av erage Return
Inv estment Arithmetic (% ) Geometric (% ) Standard Dev iation (% )
Canadian common stocks 10.05 8.79 16.32
U.S. common stocks (Cdn $) 11.99 10.75 16.46
Long bonds 8.30 7.91 9.50
Small stocks 12.04 9.16 25.49
TSX Venture stocks 5.25 −2.96 40.40
Inflation 3.65 3.60 3.03
Treasury bills 5.49 5.42 3.91

Ave ra g e re turns on sma ll stocks a nd TSX Ve nture stocks a re ba se d on da ta from 1970–2019 a nd 2002–2019, re spe ctive ly.

Sources: Author calculations based on data from Statistics Canada and S&P Dow Jones Indices (accessed September 30, 2020); and Globe and Mail (accessed

October 2, 2020).

Page 453

XAMPLE 12.5
More Geometric Averages
Take a look back at Figure 12.4. There, we showed the value of a $1 investment after 63
years. Use the value for the S&P/TSX Composite stocks to check the geometric average in
Table 12.5.
In Figure 12.4, the S&P/TSX Composite stocks grew to $201.89 over 63 years. The
geometric average return is thus:
1/63
Geometric average return = $201. 89 − 1 = 0.0879 = 8.79%

This 8.79% is the value shown in Table 12.5. For practice, check some of the other
numbers in Table 12.5 the same way.

Arithmetic Average Return or Geometric Average

Return?
When we look at historical returns, the difference between the geometric and arithmetic average returns isn’t
too hard to understand. To put it slightly differently, the geometric average tells you what you actually
earned per year on average, compounded annually. The arithmetic average tells you what you earned in a
typical year. You should use whichever one answers the question you want answered.
A somewhat trickier question concerns which average return to use when forecasting future wealth levels,
and there’s a lot of confusion on this point among analysts and financial planners. First, let’s get one thing
straight—if you know the true arithmetic average return, then this is what you should use in your forecast.
So, for example, if you know the arithmetic return is 10%, then your best guess of the value of a $1,000
investment in ten years is the future value of $1,000 at 10% for ten years, or $2,593.74.
The problem we face, however, is that we usually only have estimates of the arithmetic and geometric
returns, and estimates have errors. In this case, the arithmetic average return is probably too high for longer
periods and the geometric average is probably too low for shorter periods. So, you should regard long-run
projected wealth levels calculated using arithmetic averages as optimistic and short-run projected wealth
levels calculated using geometric averages as pessimistic.
As a practical matter, if you are using averages calculated over a long period of time (such as the 63 years
we use) to forecast, then you should just split the difference between the arithmetic and geometric average
returns. What this means is calculating the geometric mean market risk premium from Table 12.5:
8.79% − 5.42% = 3.37% . Our revised estimate of the market risk premium then becomes the average of

this number and the arithmetic mean risk premium on Canadian common stocks of 4.56% from
Table 12.3: (3.37% + 4.56%)/2 = 3.97% . 9
This concludes our discussion of geometric versus arithmetic averages. One last note; in the future, when
we say “average return,” we mean arithmetic, unless we explicitly say otherwise.

Concept Questions
. If you wanted to forecast what the stock market will do over the next year, should you use
an arithmetic or geometric average?
. If you wanted to forecast what the stock market will do over the next century, should you
use an arithmetic or geometric average?
 Page 454

LO4 12.6 | Capital Market Efficiency

Capital market history suggests that the market values of stocks and bonds can fluctuate widely from year to
year. Why does this occur? At least part of the answer is that prices change because new information arrives,
and investors reassess asset values based on that information.
The behaviour of market prices has been, and continues to be, extensively studied. A question that receives
particular attention is whether prices adjust quickly and correctly when new information arrives. A market is
said to be efficient if this is the case. To be more precise, in an efficient capital market, current market
prices fully reflect available information. By this we simply mean that, based on available information, there
is no reason to believe the current price is too low or too high.
The concept of market efficiency is a rich one, and much has been written about it. A full discussion of the
subject goes beyond the scope of our study of corporate finance. However, because the concept figures so
prominently in studies of market history, we briefly describe the key points here.

Price Behaviour in an Efficient Market

To illustrate how prices behave in an efficient market, suppose the 3 Dee TV Corporation (3DT) has,
through years of secret research and development, developed a television that projects TV programs into a
three-dimensional field that does not require an individual to wear 3D glasses. 3DT’s capital budgeting
analysis suggests that launching the new 3D television is a highly profitable move; in other words, the NPV
appears to be positive and substantial. The key assumption thus far is that 3DT has not released any
information about the new system, so the fact of its existence is purely inside information.
Now consider a share of stock in 3DT. In an efficient market, its price reflects what is known about 3DT’s
current operations and profitability, as well as market opinion about 3DT’s potential for future growth and
profits. The value of the new revolutionary 3D television is not reflected in its current price, however,
because the market is unaware of its existence.
If the market agrees with 3DT’s assessment of the value of the new project, 3DT’s stock price rises when
the decision to launch is made public. For example, assume the announcement is made in a press release on
Wednesday morning. In an efficient market, the price of shares in 3DT adjusts quickly to this new
information. Investors should not be able to buy the stock on Wednesday afternoon and make a profit on
Thursday. This would imply that it took the stock market a full day to realize the implication of the 3DT
press release. If the market is efficient, on Wednesday afternoon the price of 3DT shares already reflects the
information contained in that morning’s press release.
Page 455

Figure 12.7 presents three possible stock price adjustments for 3DT after its morning announcement. In
Figure 12.7, Day 0 represents the announcement day. As illustrated, before the announcement, 3DT’s
stock sells for $140 per share. The NPV per share of the new project is, say, $40, so the new price would
be $180 once the value of the new project is fully reflected.
 FIGURE 12.7
Reaction of stock price to new information in effi cient and ineffi cient markets

Efficient market reaction: The price instantaneously and correctly adjusts to and fully reflects new information; there is no tendency for subsequent increases

and decreases.

Delayed reaction: The price partially adjusts to the new information; ten days elapse before the price completely reflects the new information.

Overreaction: The price over adjusts to the new information; it “overshoots” the new price and subsequently corrects.

The solid line in Figure 12.7 represents the path taken by the stock price in an efficient market. In this
case, the price adjusts immediately to the new information and no further changes in the price of the stock
occur. The broken line in Figure 12.7 depicts a delayed reaction. Here it takes the market ten days or so
to fully absorb the information. Finally, the dotted line illustrates an overreaction and subsequent
adjustments to the correct price.

The broken line and the dotted line in Figure 12.7 illustrate paths that the stock price might take in an
inefficient market. If, for example, stock prices don’t adjust immediately to new information (the broken
line), buying stock immediately following the release of new information and then selling it several days
later would be a positive NPV activity because the price is too low when the new information is just
released.

The Efficient Markets Hypothesis

The efficient markets hypothesis (EMH) asserts that well-organized capital markets such as the TSX and
the NYSE are efficient markets, at least as a practical matter. In other words, an advocate of the EMH might
argue that while inefficiencies may exist, they are insignificant and not common.
When a market is efficient, there is a very important implication for market participants; all investments in
an efficient market are zero-NPV investments. The reason is not complicated. If prices are neither too low
nor too high, the difference between the market value of an investment and its cost is zero; hence, the NPV
is zero. As a result, in an efficient market, investors get exactly what they pay for when they buy securities,
and firms receive exactly what their stocks and bonds are worth when they sell them.
Page 456

What makes a market efficient is competition among investors and sufficient access to information. Many
individuals spend their lives trying to find mispriced stocks. For any given stock, they study what has
happened in the past to the stock price and its dividends. They learn, to the extent possible, what a
company’s earnings have been, how much it owes to creditors, what taxes it pays, what businesses it is in,
what new investments are planned, how sensitive it is to changes in the economy, and so on. Not only is
there a great deal to know about any particular company, but there is also a powerful incentive for knowing
it; namely, the profit motive. If you know more about some company than other investors in the
marketplace, you can profit from that knowledge by investing in the company’s stock if you have good news
and selling it if you have bad news.
The logical consequence of all this information being gathered and analyzed is that mispriced stocks will
become fewer and fewer. In other words, because of competition among investors and abundant access to
information, the market is becoming increasingly efficient. A kind of equilibrium comes into being where
there is just enough mispricing left for those who are best at identifying it to make a living doing so. For
most other investors, the activity of information gathering and analysis does not pay.
We can use Microsoft to illustrate the competition for information. A survey found that there are 60 analysts
on Wall Street, Bay Street, and around the world assigned to following this stock. As a result, the chances
are very low that one analyst will discover some information or insight into the company that is unknown to
the other 59.
No idea in finance has attracted as much attention as that of efficient markets, and not all the attention has
been flattering. Rather than rehash the arguments here, we are content to observe that some markets are
more efficient than others. For example, financial markets on the whole are probably much more efficient
than real asset markets. Efficiency implies that the price a firm obtains when it sells a share of its stock is a
fair price in the sense that it reflects the value of that stock given the information available about it. For
instance, shareholders do not have to worry that they are overpaying for a stock with a low dividend or some
other sort of characteristic because the market has already incorporated that characteristic into the price.
We sometimes say that the information has been “priced out.”
The concept of efficient markets can be explained further by responding to a frequent objection. It is
sometimes argued that the market cannot be efficient because stock prices fluctuate from day to day. If the
prices are right, the argument goes, then why do they change so much and so often? From our prior
discussion, these price movements are in no way inconsistent with efficiency. Investors are bombarded with
information every day. The fact that prices fluctuate is, at least in part, a reflection of that constant
information flow. For example, the Canadian government’s announcement on October 31, 2006, of its
decision to impose a new tax on income trusts came as a shock for the industry, and the S&P/TSX
Composite Index immediately plummeted by 294 points in reaction to this news. 10 This suggests the proof
that the markets are “informationally efficient.” In fact, the absence of price movements in a world that
changes as rapidly as ours would suggest inefficiency. 11
Page 457
Market Efficiency—Forms and Evidence
It is common to distinguish among three forms of market efficiency. Depending on the degree of efficiency,
we say that markets are either weak form efficient, semistrong form efficient, or strong form efficient. The
difference between these forms relates to what information is reflected in prices.
We start with the extreme case. If the market is strong form efficient, then all information of every kind is
reflected in stock prices. In such a market, there is no such thing as inside information. Thus, in our
previous 3DT example, we apparently were assuming the market was not strong form efficient.
Casual observation, particularly in recent years, suggests that inside information exists and it can be
valuable to possess; whether it is lawful or ethical to use that information is another issue. In any event, we
conclude that private information about a particular stock may exist that is not currently reflected in the
price of the stock. For example, prior knowledge of a takeover attempt can be very valuable as illustrated
by the case of David Riley, who was sentenced to six and one-half years in prison for leaking insider
information in New York in 2015. The prosecution proved that Artis Capital Management earned US$39
million based on illegal tips from Mr. Riley. 12 The Ontario Securities Commission is responsible for
enforcement of insider trading rules in Canada.
The second form of efficiency, semistrong efficiency, is the most controversial. In a market that is
semistrong form efficient, all public information is reflected in the stock price. The reason this form is
controversial is that it implies that a security analyst who tries to identify mispriced stocks using, for
example, financial statement information is wasting time because that information is already reflected in the
current price.
Studies of semistrong form efficiency include event studies that measure whether prices adjust rapidly to new
information following the efficient markets pattern in Figure 12.7. Announcements of mergers,
dividends, earnings, capital expenditures, and new issues of securities are a few examples of such events.
Although there are exceptions, event study tests for major exchanges, including the TSX, NYSE, and
NASDAQ, generally support the view that these markets are semistrong efficient with respect to the arrival
of new information. In fact, the tests suggest these markets are gifted with a certain amount of foresight. By
this, we mean that news tends to leak out and be reflected in stock prices even before the official release of
the information.

Referring back to Figure 12.7, what this means is that, for stocks listed on major exchanges, the stock
price reaction to new information is typically the one shown for an efficient market. In some cases, the price
follows the pattern shown for overreaction and correction. For example, a classic study found that stocks
recommended in the Financial Post “Hot Stock” column experienced price increases followed by declines. 1
3 Our conclusion here is that the market is mainly efficient but that there are some exceptions.

Page 458

If the market is efficient in the semistrong form, no matter what publicly available information mutual fund
managers rely on to pick stocks, their average returns should be the same as those of the average investor in
the market as a whole. Researchers have tested mutual fund performance against a market index and found
that, on average, fund managers have no special ability to beat the market. 14 This supports semistrong
form efficiency. An important practical result of such studies is the growth of index funds that follow a
passive investment strategy of investing in the market index. For example, TD Waterhouse Canadian Index
Fund invests in the S&P/TSX Composite and its performance tracks that of the index. The fund has lower
expenses than an actively managed fund because it does not employ analysts to actively research and pick
stocks. Investors who believe in market efficiency prefer index investing because market efficiency implies
that analysts will not beat the market consistently.
The third form of efficiency, weak form efficiency, suggests that, at a minimum, the current price of a stock
reflects its own past prices. In other words, studying past prices in an attempt to identify mispriced
securities is futile if the market is weak form efficient. Research supporting weak form efficiency suggests
that successive price changes are generally consistent with a random walk where deviations from expected
return are random. Tests on both the TSX and NYSE support weak form efficiency, although the results are
more conclusive for the NYSE. 15 This form of efficiency might seem rather mild; however, it implies that
searching for patterns in historical prices that identify mispriced stocks does not work in general. An
exception to this statement occurred in the hot high tech market of the late 1990s. Some investors were able
to achieve superior returns by following momentum strategies based on the idea that stocks that went up
yesterday are likely also to go up today. Day trading became very popular in this “momentum market.” 16
Although the bulk of the evidence supports the view that major markets such as the TSX, NYSE, and
NASDAQ are reasonably efficient, we would not be fair if we did not note the existence of selected contrary
results, often termed anomalies. 17 These anomalies include crashes like those in 2008 and 1987 and
seasonal movements in markets that have no rational explanation. We discuss these in detail in
Chapter 26.
In summary, what does research on capital market history say about market efficiency? At the risk of going
out on a limb, the evidence does seem to tell us three things. First, prices do appear to respond very rapidly
to new information, and the response is at least not grossly different from what we would expect in an
efficient market. Second, the future of market prices, particularly in the short run, is very difficult to predict
based on publicly available information. Third, if mispriced stocks do exist, there is no obvious means of
identifying them. Put another way, simple-minded schemes based on public information will probably not
be successful. 18
Page 459

IN THEIR OWN WORDS …

A Case of Insider Trading in Canada

Former RBC investment banking managing director Andrew Rankin narrowly avoided
criminal charges for insider trading after a seven-year legal battle with the Ontario Securities
Commission. In 2008, Rankin settled with a $250,000 fine, a lifetime ban on working in the
securities industry or as a director of a publicly traded firm, and a 10-year ban on trading
securities in Ontario.
The multiple charges of insider tipping were based on Rankin leaving secret documents “in
the open” in his home and letting his friend Daniel Duic use the home unsupervised. Rankin
claimed he trusted Duic and that the information leak was accidental. Duic appears to have
made $4.5 million on the related trades and then confessed to insider trading. Duic also
avoided criminal charges in part by agreeing to testify against his friend. He repaid $1.7
million of the proceeds.
The information and trades were related to Rankin’s investment banking work on
acquisitions by Shaw Communications and TELUS Corporation and the restructuring of CP
Rail, among other deals. One of Rankin’s roles as managing director was assigning junior
staff to projects. It appears that related paperwork and notes may have been involved in
Duic’s espionage.
The negligent handling of documents was only one line of attack by the court. It also came
out that the men frequently discussed the firms and the deals. Rankin’s lawyer clarifies, “He
would have been speaking intentionally. He knows he’s talking. He knows he’s talking to his
friend and as he’s doing so, he does impart in some conversations some confidential
material information, but the real flaw here, the central fact here is that at the time he wasn’t
thinking about the fact that he was imparting this crucial information. He sort of let his guard
slip. He was having conversations with his trusted personal friend he’s been close to since
high school.”
In the end, both men avoided prison and criminal charges, and Duic kept millions of illegal
profits, despite both confessing. However, the OSC can claim a partial victory for
enforcement and helped to send the message that the Canadian markets cannot be
abused.
Sources: Ontario Securities Commission, The Securities Act R.S.O. 1990, c. S.5 as Amended vs. Andrew Rankin: Reasons and Decision.

[Link] Ontario Securities Commission, R.S.O. 1990, C. S.5, as Amended vs. Andrew Stuart

Netherwood Rankin: Settlement Agreement, [Link]

Concept Questions
. What is an efficient market?
. What are the three different forms of market efficiency?
. What evidence exists that major stock markets are efficient?
. Explain anomalies in the efficient market hypothesis.
Summary and Conclusions

This chapter explores the subject of capital market history. Such history is useful because it tells
us what to expect in the way of returns from risky assets. We summed up our study of market
history with two key lessons:
1. Risky assets, on average, earn a risk premium. There is a reward for bearing risk.
2. The greater the risk from a risky investment, the greater is the required reward.

These lessons have significant implications for financial managers. We consider these implications
in the chapters ahead.
Page 460

We also discussed the concept of market efficiency. In an efficient market, prices adjust quickly and
correctly to new information. Consequently, asset prices in efficient markets are rarely too high or
too low. How efficient capital markets (such as the TSX and NYSE) are is a matter of debate, but,
at a minimum, they are probably much more efficient than most real asset markets.
Key Terms
arithmetic average return
efficient capital market
efficient markets hypothesis (EMH)
geometric average return
normal distribution
risk premium
standard deviation
value at risk (VaR)
variance
Chapter Review Problems
and Self-Test
1. Recent Return History Use Table 12.1 to calculate the average return over the five
years 2010–2014 for Canadian common stocks, small stocks, and Treasury bills.
2. More Recent Return History Calculate the standard deviations using information from
Problem 12.1. Which of the investments was the most volatile over this period?
Answers to Self-Test Problems
1. We calculate the averages as follows:

Year TSX Small T-bills

2010 0.1727 0.3610 0.0050
2011 −0.0857 −0.1950 0.0100
2012 0.0541 −0.0119 0.0100
2013 0.0955 0.0448 0.0100
2014 0.0742 −0.0267 0.0090
Average 0.0622 0.0344 0.0088

2. We first need to calculate the deviations from the average returns. Using the averages from
Problem 12.1, we get:

Year TSX Small T-bills

2010 0.1105 0.3266 −0.0038
2011 −0.1479 −0.2294 0.0012
2012 −0.0081 −0.0463 0.0012
2013 0.0333 0.0104 0.0012
2014 0.0120 −0.0611 0.0002

Page 461

We square the deviations and calculate the variances and standard deviations:

Year TSX Small T-bills

2010 0.012219 0.106641 0.000014
2011 0.021863 0.052643 0.000001
2012 0.000065 0.002147 0.000001
2013 0.001112 0.000107 0.000001
2014 0.000145 0.003738 0.000000
Variance 0.008851 0.041319 0.000004
Standard deviation 0.0940798 0.2032708 0.0020616

To calculate the variances, we added the squared deviations and divided by four, the number of
returns less one. Notice that the small stocks had substantially greater volatility with a higher
average return. Once again, such investments are risky, particularly over short periods.
Concept Review
and Critical Thinking Questions
1. (LO4) Given that Nortel was up by more than 300% in the 12 months ending in July 2000, why
didn’t all investors hold Nortel?
2. (LO4) Given that Hayes was down by 98% for 1998, why did some investors hold the stock?
Why didn’t they sell out before the price declined so sharply?
3. (LO2, 3) We have seen that, over long periods of time, stock investments have tended to
substantially outperform bond investments. However, it is not at all uncommon to observe
investors with long horizons holding only bonds. Are such investors irrational?
4. (LO4) Explain why a characteristic of an efficient market is that investments in that market have
zero NPVs.
5. (LO4) A stock market analyst is able to identify mispriced stocks by comparing the average
price for the last ten days to the average price for the last 60 days. If this is true, what do you
know about the market?
6. (LO4) If a market is semistrong form efficient, is it also weak form efficient? Explain.
7. (LO4) What are the implications of the efficient markets hypothesis for investors who buy and
sell stocks in an attempt to “beat the market”?
8. (LO4) Critically evaluate the following statement: Playing the stock market is like gambling.
Such speculative investing has no social value, other than the pleasure people get from this form
of gambling.
9. (LO4) There are several celebrated investors and stock pickers frequently mentioned in the
financial press who have recorded huge returns on their investments over the past two decades.
Is the success of these particular investors an invalidation of the EMH? Explain.
Page 462

10. (LO4) For each of the following scenarios, discuss whether profit opportunities exist from
trading in the stock of the firm under the conditions that (1) the market is not weak form
efficient, (2) the market is weak form but not semistrong form efficient, (3) the market is
semistrong form but not strong form efficient, and (4) the market is strong form efficient.
a. The stock price has risen steadily each day for the past 30 days.
b. The financial statements for a company were released three days ago, and you believe you’ve
uncovered some anomalies in the company’s inventory and cost control reporting techniques
that are causing the firm’s true liquidity strength to be understated.
c. You observe that the senior management of a company has been buying a lot of the
company’s stock on the open market over the past week.
Questions and Problems

Basic (Questions 1–12)

1. Calculating Returns (LO1) Suppose a stock had an initial price of $79 per share, paid a
dividend of $1.45 per share during the year, and had an ending share price of $88. Compute
the percentage total return.
2. Calculating Yields (LO1) In Problem 1, what was the dividend yield? The capital gains
yield?
3. Return Calculations (LO1) Rework Problems 1 and 2 assuming the ending share
price is $71.
4. Calculating Returns (LO1) Suppose you bought a 7% coupon bond one year ago for
$970. The bond sells for $940 today.
a. Assuming a $1,000 face value, what was your total dollar return on this investment over
the past year?

b. What was your total nominal rate of return on this investment over the past year?

c. If the inflation rate last year was 3%, what was your total real rate of return on this
investment?

5. Nominal versus Real Returns (LO2) What was the average annual return on Canadian stock
from 1957 through 2014:
a. In nominal terms?

b. In real terms?

6. Bond Returns (LO2) What is the historical real return on FTSE TMX Canada long-term
bonds?
Page 463
7. Calculating Returns and Variability (LO1) Using the following returns, calculate the
arithmetic average returns, the variances, and the standard deviations for X and Y.

Returns
Year X Y
1 15% 21%
2 26 36
3 7 13
4 −13 −26
5 11 15
 8. Risk Premiums (LO2, 3) Refer to Table 12.1 in the text and look at the period from
1970 through 1975.
a. Calculate the arithmetic average returns for Canadian large-company stocks and T-bills
over this period.

b. Calculate the standard deviation of the returns for Canadian large-company stocks and T-
bills over this period.

c. Calculate the observed risk premium in each year for the Canadian large-company
stocks versus the T-bills. What was the average risk premium over this period? What was
the standard deviation of the risk premium over this period?

d. Is it possible for the risk premium to be negative before an investment is undertaken?

Can the risk premium be negative after the fact? Explain.

9. Calculating Returns and Variability (LO1) You’ve observed the following returns on
Regina Computer’s stock over the past five years: 7%, −12%, 11%, 38%, and 14%.
a. What was the arithmetic average return on Regina’s stock over this five-year period?

b. What was the variance of Regina’s returns over this period? The standard deviation?

10. Calculating Real Returns and Risk Premiums (LO1) For Problem 9, suppose the
average inflation rate over this period was 3.5% and the average T-bill rate over the period
was 4.2%.
a. What was the average real return on Regina’s stock?

b. What was the average nominal risk premium on Regina’s stock?

11. Calculating Real Rates (LO1) Given the information in Problems 9 and 10, what was
the average real risk-free rate over this time period? What was the average real risk premium?
12. Effects of Inflation (LO2) Look at Table 12.1 and Figure 12.4 in the text. When were
T-bill rates at their highest over the period from 1957 through 2019? Why do you think they
were so high during this period? What relationship underlies your answer?
Page 464

Intermediate (Questions 13–20)

13. Calculating Investment Returns (LO1) You bought one of Glenelm Co.’s 6.5% coupon
bonds one year ago for $1,090. These bonds make annual payments and mature 14 years
from now. Suppose you decide to sell your bonds today when the required return on the
bonds is 5.2%. If the inflation rate was 3.9% over the past year, what was your total real
return on investment?
14. Calculating Returns and Variability (LO1) You find a certain stock that had returns of 9%,
−16%, 21%, and 17% for four of the last five years. If the average return of the stock over
 this period was 10.3%, what was the stock’s return for the missing year? What is the
standard deviation of the stock’s return?
15. Arithmetic and Geometric Returns (LO1) A stock has had returns of 9%, 21%, 32%, −18%,
27%, and −12% over the last six years. What are the arithmetic and geometric returns for the
stock?
16. Arithmetic and Geometric Returns (LO1) A stock has had the following year-end prices and
dividends:

Year P rice Div idend

1 $60.18 −
2 73.66 $0.60
3 94.18 0.64
4 89.35 0.72
5 78.49 0.80
6 95.05 1.20

What are the arithmetic and geometric returns for the stock?
17. Using Return Distributions (LO3) Suppose the returns on long-term corporate bonds are
normally distributed. Based on the historical record, what is the approximate probability
that your return on these bonds will be less than −2.2% in a given year? What range of
returns would you expect to see 95% of the time? What range would you expect to see 99%
of the time?
18. Using Return Distributions (LO3) Assuming that the returns from holding small-company
stocks are normally distributed, what is the approximate probability that your money will
double in value in a single year? What about triple in value?
19. Distributions (LO3) In Problem 18, what is the probability that the return is less than
−100%? What are the implications for the distribution of returns?
20. Calculating Returns (LO2, 3) Refer to Table 12.1 and look at the period from 1973
through 1980:
a. Calculate the average return for Treasury bills and the average annual inflation rate
(consumer price index) for this period.

b. Calculate the standard deviation of Treasury bill returns and inflation over this period.

c. Calculate the real return for each year. What is the average real return for Treasury bills?

d. Many people consider Treasury bills risk-free. What do these calculations tell you about
the potential risks of Treasury bills?

Page 465

Challenge (Questions 21–22)

21. Using Probability Distributions (LO3) Suppose the returns on Canadian stocks are
 normally distributed. Based on the historical record, use a cumulative normal probability
table (rounded to the nearest table value) to determine the probability that in any given year
you will lose money by investing in common stock. 19
22. Using Probability Distributions (LO3) Suppose the returns on FTSE TMX Canada long-
term bonds and T-bills are normally distributed. Based on the historical record, use a
cumulative normal probability table (rounded to the nearest table value) to answer the
following questions:
a. What is the probability that in any given year, the return on long-term corporate bonds
will be greater than 10%? Less than 0%?

b. What is the probability that in any given year, the return on T-bills will be greater than
10%? Less than 0%?

c. In 1981, the return on FTSE TMX Canada long-term bonds was −2.09%. How likely is
it that such a low return will recur at some point in the future? T-bills had a return of
19.11% in this same year. How likely is it that such a high return on T-bills will recur at
some point in the future?
MINI CASE

A Job at Hillsdale Inc.

You recently graduated from university, and your job search led you to Hillsdale Inc.
Because you felt the company’s business was taking off, you accepted a job offer. The
first day on the job, while you are finishing your employment paperwork, Shane
Shillingford, who works in finance, stops by to inform you about the company’s defined
contribution (DC) pension plan.
A DC pension plan is a retirement plan offered by many companies. Such plans are tax-
deferred savings vehicles, meaning that any deposits you make into the plan are
deducted from your current pre-tax income, so no current taxes are paid on the money.
For example, assume your salary will be $100,000 per year. If you contribute $6,000 to
the DC pension plan, you will pay taxes on only $94,000 in income. There are also no
taxes paid on any capital gains or income while you are invested in the plan, but you do
pay taxes when you withdraw money at retirement. As is fairly common, the company
also has a 5% match. This means that the company will match your contribution up to 5%
of your salary, but you must contribute to get the match.
The DC pension plan has several options for investments, most of which are mutual
funds. A mutual fund is a portfolio of assets. When you purchase shares in a mutual fund,
you are actually purchasing partial ownership of the fund’s assets. The return of the fund
is the weighted average of the return of the assets owned by the fund, minus any
expenses. The largest expense is typically the management fee, paid to the fund
manager. The management fee is compensation for the manager, who makes all of the
investment decisions for the fund.
Hillsdale Inc. uses TD Canada Trust as its DC pension plan administrator. Here are the
investment options offered for employees:
Company Stock One option in the DC pension plan is stock in Hillsdale Inc. The
company is currently privately held. However, when you interviewed with the owner, Kevin
Cooper, he informed you the company stock was expected to go public in the next three
to four years. Until then, a company stock price is simply set each year by the board of
directors.
Page 466

TD Canadian Index Fund This mutual fund tracks the S&P/TSX Composite. Stocks in
the fund are weighted exactly the same as the S&P/TSX Composite. This means the fund
return is approximately the return on the S&P/TSX Composite, minus expenses. Because
an index fund purchases assets based on the composition of the index it is following, the
fund manager is not required to research stocks and make investment decisions. The
result is that the fund expenses are usually low. The TD Canadian Index Fund charges
expenses of 0.88% of assets per year.
TD Canadian Small-Cap Equity Fund This fund primarily invests in small-capitalization
stocks. As such, the returns of the fund are more volatile. The fund can also invest 10% of
its assets in companies based outside Canada. This fund charges 2.53% in expenses.
TD Canadian Blue Chip Equity Fund This fund invests primarily in large-capitalization
stocks of companies based in Canada. The fund is managed by Margot Richie and has
outperformed the market in six of the last eight years. The fund charges 2.34% in
expenses.
TD Canadian Bond Fund This fund invests in long-term corporate bonds issued by
Canada-domiciled companies. The fund is restricted to investments in bonds with an
investment-grade credit rating. This fund charges 1.11% in expenses.
TD Canadian Money Market Fund This fund invests in short-term, high–credit quality
debt instruments, which include Treasury bills. As such, the return on the money market
fund is only slightly higher than the return on Treasury bills. Because of the credit quality
and short-term nature of the investments, there is only a very slight risk of negative return.
The fund charges 0.77% in expenses.

Questions
. What advantages do the mutual funds offer compared to the company stock?
. Assume that you invest 5% of your salary and receive the full 5% match from Hillsdale
Inc. What EAR do you earn from the match? What conclusions do you draw about
matching plans?
. Assume you decide you should invest at least part of your money in large-
capitalization stocks of companies based in Canada. What are the advantages and
disadvantages of choosing the TD Canadian Blue Chip Equity Fund compared to the
TD Canadian Index Fund?
. The returns on the TD Canadian Small-Cap Equity Fund are the most volatile of all the
mutual funds offered in the DC pension plan. Why would you ever want to invest in this
fund? When you examine the expenses of the mutual funds, you will notice that this
fund also has the highest expenses. Does this affect your decision to invest in this
fund?
. A measure of risk-adjusted performance that is often used is the Sharpe ratio. The
Sharpe ratio is calculated as the risk premium of an asset divided by its standard
deviation. The standard deviation and return of the funds over the past ten years are
listed in the following table. Calculate the Sharpe ratio for each of these funds. Assume
that the expected return and standard deviation of the company stock will be 18% and
70%, respectively. Calculate the Sharpe ratio for the company stock. How appropriate
is the Sharpe ratio for these assets? When would you use the Sharpe ratio?

10-Year

Fund Annual Return (%) Standard Deviation (%)

TD Canadian Index 11.48 15.82

 10-Year

TD Canadian Small-Cap Equity 16.68 19.64

TD Canadian Blue Chip Equity 11.85 15.41

TD Canadian Bond 9.67 10.83

Source: The Globe and Mail, Mutual Funds, [Link]/globe-investor/funds-and-etfs/funds.

. What portfolio allocation would you choose? Why? Explain your thinking carefully.