Investment Returns and Aggregate Measures of Stock Markets

1
Chapter 10

• Investment Returns and Aggregate Measures of
  Stock Markets

2
Measures of Stock Performance

• Averages and Indices
• Different means to calculate an average
• Price-weighted
• Value-weighted
• Equal-weighted
• Geometric

3
A Price-weighted Average

• Price of stock A 10
• Price of stock B 20
• Price-weighted average is (10 20)/2 15

4
A Value-weighted Average

• Weights the prices by the number of shares
  outstanding

5
A Value-weighted Average

• If number of shares outstanding of stocks A and B
  are
• A 1,000,000
• B 10,000,000

6
Total Value of Each Stock

• A 10,000,000
• B 200,000,000

7
Weighted Average Price

• 210,000,000/(1,000,000 10,000,000) 19.09

8
An Equal-weighted Average

• Equal dollar amount invested in each stock
• If prices are 10 and 20
• buy two shares of A for every share of B
• 20 invested in each stock.
• Average price of a share 40/3 13.33

9
A Geometric Average

• Instead of dividing, take the 1/n root (the
  reciprocal of n)
• Average price of a share (10)(20).5 14.14

10
Averages and Indices

• Compare prices over time or use one year as a
  base
• In an index subsequent prices are expressed
  relative to the base year.

11
Differences in Measures

• Different methods for calculating averages
• The selection of a base year
• Can produce different measures of stock
  performance

12
Aggregate Measures of the Stock Market Include

• Dow Jones industrial average
• Standard Poor's 500 stock index
• NYSE composite index
• Value Line Stock average
• Nasdaq composite index
• Wilshire 5000 index

13
Price Movements and Graphs

• How stock prices appear to have changed is
  affected by the presentation.
• Impact of absolute and relative scales

14
Price Movements and Graphs
15
Additional Aggregate Measures of the Stock Market

• Russell 1000
• Russell 2000
• Russell 3000
• SP 400 MidCap

• SP 600 SmallCap
• SP 1500
• Nasdaq Index
• Wilshire 5000 Index

16
Aggregate Measures of the Stock Market

• Tend to move together
• Highly correlated

17
Stock Prices

• May be deflated to determine investors' increase
  in purchasing power

18
Percentage Change in Real Terms
19
The Holding Period Return (HPR)

• The percentage earned on an investment during a
  period of time
• HPR P1 D - P0 P0

20
The Holding Period Return

• Major weakness
• Does not consider the length of time
• One year and ten years are the same

21
Rate of Return

• Rate that equates
• the cost of an investment (cash outflow) with
• the cash inflows generated
• Gives the true annualized (compound) return

22
Internal Rate of Return (r)

• Also called the dollar-weighted rate of return
• P0 D1 D2 Dn Pn (1r) (1r)2
  (1r)n (1r)n
• Solve for r

23
Issues with the Internal Rate of Return

• Assumes cash flows are reinvested at that
  internal rate of return
• Adjustments are necessary if more than one
  purchase or sale is made.

24
Time-weighted Rate of Return

• An alternative to the internal rate of return
• Ignores the dollar amount invested
• Uses the return for each time period
• Computes the geometric average return

25
Investment Returns

• Studies indicate stocks earn 9 to 12 percent
  annually.
• The Ibbotson results (the industry benchmark)
• Large company stocks 10.2
• Small company stocks 12.1

26
Ibbotson Results

• For different time horizons

27
Averaging Strategies

• Dollar cost averaging - the periodic purchase
• Averaging down - buying additional shares after
  prices fall