Chapter 6:

Historical Returns:
o S&P has grown of 10% over time
o Future is not going to e e!actl" li#e the past$ ut it is a goo%
pre%iction&
't(s the est guess of relative returns
o )ong run historical:
Converte% into the future
*reater reliailit" factor of the future
o Short run historical:
Coul% get all over the place
+' have no i%ea,
Total return:
o -otal Return . Price /ppreciation01epreciation 2 Cash flows 34iel%5
6suall" 10%
/ppreciation: *oes from 100 107
1epreciation: *oes from 100 87
o 1ivi%en% "iel%:
9! 1:%: 4ou also have to a%% appreciation or %epreciation
;ust ecause it has a high %ivi%en% "iel% %oesn(t mean that
"ou(ll have a high return&
o Stoc#s pa" out %ivi%en%s
o <on%s pa" out coupons
Cumulative Wealth Index:
o C=' will actuall" tell "ou how much "ou(ve earne%
-he amount of how much "our initial investment will go
up0%own "&
Foreign Exchange
o Foreign currenc" a%>ustment
o F?: *ain an% losses
Political ris#
Countr" ris#
o 4ou have to a%% the currenc" a%>ustment when converting the price of
the securities&
o -wo elevators wor#ing at the same time
-he foreign currenc" changes
-he actual local investment
Arithmetic Mean
o 6suall" when "ou want to pre%ict something within one period
o @a#ing "our est guess within one "ear$ use /rithmetic @ean
Geometric Mean
o 6suall" when "ou want to pre%ict something within several periods
o @a#ing est pre%ictions over a longer perio% of time&
o -he relationship is that geometric is alwa"s less than the arithmetic
Inflation Adjusted Return
o 9stimate:
Real return: Aominal B 'nflation
o /ctual:
Real Return: Aominal 0 CP'
Ris
o Ris# is the %ifference etween the actual an% e!pecte% return
o Ris# sources:
'nterest rate ris#
@ar#et ris# !<roa% concept5
o =ars$ asteroi%s$ recession$ inflation
Financial ris#
o )everage . %et
)iCui%it" ris#
Foreign Currenc" ris#
Countr" Ris#
Measure Ris
o Stan%ar% %eviation$ variance$ %ispersion of outcome$ volatilit"
o Calculation of stan%ar% %eviation&
"tandard deviation
o -otal ris# 3S&15:
S"stemic ris# 3<eta5
AonDs"stemic ris# 3Compan" ris#5
o / measure of %ispersion
o 1 S&1 . 67%
9!pecte%
)ess ris#"
o E S&1 . 87%
Fin% of rare
@ore ris#"
o G S&1 . 88%
Rare events
/ aseall pla"er hit : homeruns
/ return of :G% is prett" rare if "ou e!pect 1E%
+100 "ear floo%,: usuall" happens once in hun%re% "ears
Her" ris#"$ avoi%&
o Tail ris#
Small change of a huge loss
Major asset classes
o Historical returns:
'nflation: G%
-Dills: G%
Corp <on%s: :DI%
-Don%s: GD7%
S&P 700: 0%
Small Cap: 1E%
$eta
o -he ris# of the mar#et
o 9ffect ever"one
o 't(s nonD%iversifiale
9!ample: 'nflation$ interest rates$ wars$ asteroi%s
Ris premium
o 9!tra cost0"iel%0value aove an% e"on% the normal ris#
o E%uit& Ris 'remium: =hat a%%itional return can "ou e!pect to get if
"ou %iversif" "our portfolio
Historical: 6%