Posted: May 27th, 2015

25. How can an investor lose money on a stock while making money on a bond investment if there is a reward for bearing risk? Aren’t stocks riskier than bonds?

25. How can an investor lose money on a stock while making money on a bond investment if there is a reward for bearing risk? Aren’t stocks riskier than bonds?

Feedback: Refer to section 12.3

86. There is a reward for bearing risk over the long-term. However, the nature of risk implies the returns on a high-risk security will be more volatile than the returns on a low risk security. Thus, stocks can produce lower returns in the short run. It is the acceptance of this risk that justifies the potential long-term reward.

26. Shawn earned an average return of 14.6 percent on his investments over the past 20 years while the S&P 500, a measure of the overall market, only returned an average of 13.9 percent. Explain how this can occur if the stock market is efficient.

An investor can purchase securities that have a higher level of risk than the overall market.
In an efficient market, these securities will earn a higher return over the long-term as compensation for the assumption of the increased risk. This is the first lesson of the capital markets: There is a reward for bearing risk.

27. What are the two primary lessons learned from capital market history? Use historical information to justify that these lessonsare correct.

First, there is a reward for bearing risk, and second, the greater the risk, the greater the potential reward. As evidence, students should provide a brief discussion of the historical rates of return and the related standard deviations of the various asset classes discussed in the text.

28. Explain the difference between systematic and unsystematic risk. Also explain why one of these types of risks is rewarded with a risk premium while the other type is not.

Unsystematic, or diversifiable, risk affects a limited number of securities and can be eliminated by investing in securities from various industries and geographic regions. Unsystematic risk is not rewarded since it can be eliminated by investors. Systematic risk is risk which affects most, or all, securities and cannot be diversified away. Since systematic risk must be accepted by investors it is rewarded with a risk premium and is measured by beta.