14. Risk and Return of Equity, the Capital Asset Pricing Model, and Stock Selection for Efficient Portfolio Construction

Individual investors must be compensated for bearing risk. It seems intuitive to the reader that there should be a direct linkage between the risk of a security and its rate of return. We are interested in securing the maximum return for a given level of risk, or the minimum risk for a given level of return. The concept of such risk-return analysis is the efficient frontier of Harry Markowitz (1952, 1959). If an investor can invest in a government security, which is backed by the taxing power of the federal government, then that government security is relatively risk-free. The 90-day Treasury bill rate is used as the basic risk-free rate. Supposedly, the taxing power of the federal government eliminates default risk of government debt issues. A liquidity premium is paid for longer-term maturities, due to the increasing level of interest rate risk. Investors are paid interest payments, as determined by the bond’s coupon rate, and may earn market price appreciation on longer bonds if market rates fall or losses if market rates rise. During the period from 1928 to 2017, Treasury bills returned 3.44%, longer-term (10-year Treasury) government bonds earned 5.15%, and corporate stocks, as measured by the stock of the S&P 500 index, earned 11.53% annually, as measured by the mean annual return. The annualized standard deviations are 3.06%, 7.72%, and 19.66%, respectively, for Treasury bills, Treasury bonds, and S&P stocks. The risk-return trade-off has been relevant for the 1928–2017 period. The correlation coefficient between annual returns for Treasury bills and the S&P 500 stock returns were −0.030 for the 1928–2017 time period. This was essentially no correlation between Treasury bills and large stocks, as measured by the S&P 500 stock. The correlation coefficient between annual returns for Treasury bonds and the S&P 500 stock returns was 0.30 for the 1928–2017 time period. Why do corporate stocks offer investors higher returns for stocks than bonds?