JAMES P. WESTON: Hi, welcome back to Finance for Non-finance Professionals. In this lesson, we're going to talk about Risk, Return and the Cost of Capital. We're going to talk about historical rates of return, comparing debt and equity. Now, this picture kind of sums up the entire lesson today. If we look at what we've got graphed here on these five different lines. I've got five different asset classes. And what I've got here is if we go all the way back to 1927, which is where I'm starting the analysis here for the United States. What I'm going to do is I'm going to take a dollar bill and then put a dollar bill into five different things. The first thing that I'm going to do is I'm just going to let that dollar bill rise at the general rate of goods and services. So that's inflation-- how much do prices tend to go up in the economy. And that's the red line. And you can sort of track the red line as it goes and it comes all the way up here. And the red line ends somewhere right around here. Which means if I put my money in a basket of goods and surfaces, that dollar, roughly a hundred years later, would be worth about $10. OK. So prices have gone up about 10 times over the last hundred years. The next thing that I could do is take that dollar and I could put it in short-term treasury bills. That's that sort of peach line or light yellow line here. And if I track that, that's a relatively smooth line also. And that line winds up, after about a hundred years, at around $12. So if I put my money in short-term treasuries, I'd have $12 or $13 at the end of that roughly hundred years. The next thing I do is I take that dollar bill, again, put it into long-term treasury bonds, 10-year, consummate maturity bonds. I take that dollar bill in 1927 and I let it grow over roughly a hundred years, 95 years. And what I wind up with is about, that's about $85, a hundred years later. Notice that this is a log scale on the y-axis. Every time I go up one line, it's not going up by one unit, it's going up by a factor of 10, so from 10 to 100 to 1,000 to 10,000. The next thing that I do is I take that dollar bill and I put it in corporate bonds, BAA constant, maturity-rated bonds. As I track that, it's a little bit more wiggly. And it winds up at around $70 or $80. No, no, no more than that. Around $150 at the end of a hundred years. OK. The last thing that I do is I take that $1 and I put it in the stock market, the overall stock market. So like the S&P 500 or some big index, all stocks. I take that dollar, put it in 1927, and just let it rise and fall with the stock market overall. Well, that line's a lot wigglier. Right, sometimes it goes way down, and sometimes it goes way down, but it wiggles around a lot. Sometimes it has big crashes. Sometimes it has big peaks. But overall, over the long run, over that hundred years, it goes up. It goes way up. And I would have roughly $500, oh, sorry, $1,500 by the time that hundred years is finished. So what do I learn from this graph? What I learned from this graph is that as I increase the risk of what I put my money in, I wind up with more money later. In other words, the riskier asset I buy, the greater my return. Now one of the amazing things about just looking at this graph of the U.S. economy over the last hundred years, is nobody made it be that way. The Federal Reserve didn't make these graphs line up. The government didn't make these graphs line up. All these assets-- stocks, bonds, corporate bonds, goods and services in the economy-- are being traded by private individuals in a free market. What happens is, or at least in the U.S., over the last hundred years, as people buy and sell those different assets, they buy and sell them through discounting. So that the assets reflect a return to investors who put their money in stocks or put their money in corporate bonds or put their money in treasuries. They wind up earning a return based on the prices that they paid. It lines up almost exactly with risk. The more risk I take, the more return I get. Nothing made it that way. It just worked out that way. It should, right? It should. In the capital markets, the whole idea of capitalism, is that capital markets direct capital from bad companies to good companies. If that works out right, then investors ought to be compensated for taking more risk. It turns out, at least through this simple graph, that they are. If I take this graph, this pictorial, and turn it into data. In other words, take this picture and make a data table out of it. That's what we're looking at here. So if I think about that line where I put that dollar into the basket of commodities and let it grow at inflation, average inflation, along that line was around 3%, plus or minus, 4.2%. At one point, prices went down 10%, but most of the time, 75% of the time they were going up with a maximum inflation of 18%. That was around 1980. Treasury bills, short-term treasuries, less than a year, offered around 3 1/2%, treasury bonds, 5.2%, corporate bond, 7.2% and stocks around 11% or 12%. OK. So what we've learned from this is that on average, the stock market over the last hundred years in the U.S. goes up around 11% or 12% a year. That seems great. Why not just put all your money in stock? That's going to give you the best return. Because if I look at the standard deviation, which is a measure of how much that line wiggles, those lines wiggle-- treasury bills, plus or minus 3%; bonds, plus or minus 8%; stocks, plus or minus 20%. That's a huge variation. That's a lot of risk. In fact, the minimum one year, the stock market went down minus 43%. That's a big, that was at the start of World War II. That's a really big hit. In fact, 55% of the time, the stock market was way down. The maximum return was 52%, the minimum return minus 43%. Those are terrible returns. That stock market line wiggles an awful lot. So if I think about the trade off between risk and return, stocks have an awful lot more risk than do treasury bonds. OK. In the long run, stocks tend to do better. But you might have to wait 10, 20, 30 years for them to do a lot better because they wiggle so much. They have a huge volatility. That means that if I put my money in stocks, as an investor, I'm going to require a higher discount rate. I need a better rate of return. Otherwise, why not just put my money in treasuries? OK, to think about risk of return, remember that risk of return, of any asset was the risk free rate plus some risk premium. And so what we need to think about is the fact that the more risk is going to drive higher returns because of the time value of money, opportunity costs and inflation. The three things that we talked about back in lesson one when we first started talking about compounding. What we need to think about now is how to put a risk premium on those assets. OK, to sum up, stocks returned around 11% or 12%. Interest rates were around 6% historically. Stock volatility is much higher. And long rates tend to be higher than short rates. We're going to use that information now to try and put actual rates on equity and debt in the next lesson.
