###### Capital Allocation Line (CAL) and Capi ...

We form a capital allocation line when we combine a risky asset portfolio... **Read More**

All asset classes have risk and return characteristics. Historical returns are neither forward-looking nor expected returns. Nevertheless, it is noteworthy that by examining the performance of the historical returns, we can understand the likely characteristics of a particular asset class.

The examination of an 83-year period, from 1926 to 2008, provides investors with annual return data. The data is often used to forecast the expected mean return for the asset classes. The major asset classes have produced the following annual nominal returns for the United States:

- US Large Company Stocks: 9.6%.
- US Small Company Stocks: 11.7%.
- US Long-term Corporate Bonds: 5.9%.
- US Long-term Government Bonds: 5.7%.
- US Treasury Bills: 4.0%.

Over this period of 83 years, the US inflation rate has averaged 3.0%. However, inflation has varied widely. Therefore, the use of real, inflation-adjusted returns is more appropriate, particularly when comparing asset class returns globally.

Using data from 1900 to 2008, an examination of nominal versus real returns global asset classes can be made. In nominal terms, world equities returned 8.4%, while world bonds returned 4.8%. The corresponding real returns are 5.2% and 1.8%, respectively.

We cannot examine returns without examining the associated risk to each asset class. Risk, in this context, is measured by a standard deviation metric. By examining the United States’ nominal returns over the period between 1926 to 2008, we observe the following standard deviations:

- US Large Company Stocks: 20.6%.
- US Small Company Stocks: 33.0%.
- US Long-term Corporate Bonds: 8.4%.
- US Long-term Government Bonds: 9.4%.
- US Treasury Bills: 3.1%.

Using nominal world data from 1900 to 2008, we note that the standard deviation for world equities is 17.3% and 8.6% for world bonds.

A risk-return tradeoff refers to the relationship between risk and return. Ideally, if you want to achieve a higher return, you must accept a higher level of risk. Reviewing the US nominal asset class data, it can be noted that small company stocks delivered the highest return over the period (11.7%) despite bearing the highest risk (33.0%).

The risk premium is the extra returns investors can expect for assuming additional risk after accounting for the nominal risk-free interest rate. The world equity risk premium over bonds is 3.4%. This is the additional return investors can hope to achieve from equities over bonds due to the additional equity risk.

An assumption of a normal distribution of returns is made by making use of a mean and standard deviation when evaluating asset class characteristics. However, within a financial market context, an assumption of normality is flawed since returns are not normally distributed. The probability of extreme events is greater than a normal distribution suggests. An examination of the skewness and kurtosis of a distribution is required.

Skewness is a measure of the asymmetry of a return distribution. If more returns are concentrated on the right end of the distribution, the returns are said to be negatively skewed and vice versa. Generally, stock returns tend to be negatively skewed.

Kurtosis refers to the “fat tails” of the distribution. That is, the greater probability of extreme events than would ordinarily be assumed by a normal distribution.

Although not a function of the return distribution, liquidity is an important market factor that contributes to the risk of an investment. Liquidity tends to excite more concern in emerging markets than in developed markets. This trend is attributable to smaller trading volumes in those markets. It is equally a cause for concern for potentially more risky asset classes such as low-credit quality corporate bonds.

QuestionSkewness is

most likely:A. A measure of the asymmetry of the probability distribution.

B. A measure of the “tailedness” of the probability distribution.

C. A measure that is used to quantify the amount of variation or dispersion of a set of data values.

SolutionThe correct answer is

A.Skewness is a measure of the asymmetry of a return distribution.

Option B is incorrect. It is the definition of kurtosis.

Option C is incorrect. It is the definition of standard deviation.