Question

In Ch.12, the concept of risk and return is discussed. In 500 words or more, discuss the historical return and risks on various types of investments. Additionally, briefly explain the implications of market efficiency.

Answer 1

Historical returns can be defined as the performance of a security or index in the past. Financial analysts are analyzing the data to predict how a security in the future is likely to work. It is also possible to use the same data to predict how consumer behavior will affect a security. While a security's past performance may be useful in predicting future behaviour, experts warn that it is never a guaranteed process. The general rule is that the older the data, the less useful it will be to forecast near-future behavior and to direct future investment decisions.

Of money, as calculated by historical prices from 3-month Treasury bills, the annualized return since 1928 was about 3.4 percent. When this article was last updated, cash returns for high-yield saving accounts, money market accounts and short-term deposit certificates (CDs) were in the range of 1.5 to 2.5 percent. The risk of cash holdings declining is close to zero if we ignore the inflationary effects. For several decades, equities have held their position as the greatest return. Around 1925 and 2007, stock returns for 53 of the 82 years were positive and 29 of the 82 years were negative. Since the start of the same era, stocks have managed to do better than bonds by a margin of 2-1. While bonds have historically been considered a more stable financial asset, they can still fluctuate in much the same way as a portfolio.

This principle is called the Efficient Market Hypothesis (EMH), which claims that the market is capable of pricing securities correctly in a timely manner based on the latest available information. There is no undervalued stock to have on the basis of this principle, since each stock is always trading at a price equal to its intrinsic value.

There are several variants of EMH that specify how strict are the assumptions necessary to hold in order to make it valid. The hypothesis has its critics, however, who believe that the market overreacts to economic changes, leading to stocks being overpriced and underpriced, and they have their own historical data to back it up.