(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 203

178 PART 2 • Producers, Consumers, and Competitive Markets

• real return Simple (or
nominal) return on an asset, less
the rate of inflation.

• expected return Return
that an asset should earn on
average.
• actual return Return that an
asset earns.

10 percent.11 If an apartment building was worth $10 million last year, increased
in value to $11 million this year, and also provided rental income (after expenses)
of $0.5 million, it would have yielded a return of 15 percent over the past year. If
a share of General Motors stock was worth $80 at the beginning of the year, fell to
$72 by the end of the year, and paid a dividend of $4, it will have yielded a return
of -5 percent (the dividend yield of 5 percent less the capital loss of 10 percent).
When people invest their savings in stocks, bonds, land, or other assets, they
usually hope to earn a return that exceeds the rate of inflation. Thus, by delaying consumption, they can buy more in the future than they can by spending
all their income now. Consequently, we often express the return on an asset in
real—i.e., inflation-adjusted—terms. The real return on an asset is its simple (or
nominal) return less the rate of inflation. For example, with an annual inflation
rate of 5 percent, our bond, apartment building, and share of GM stock have
yielded real returns of 5 percent, 10 percent, and −10 percent, respectively.
EXPECTED VERSUS ACTUAL RETURNS Because most assets are risky, an
investor cannot know in advance what returns they will yield over the coming year. For example, our apartment building might have depreciated in value
instead of appreciating, and the price of GM stock might have risen instead of
fallen. However, we can still compare assets by looking at their expected returns.
The expected return on an asset is the expected value of its return, i.e., the return
that it should earn on average. In some years, an asset’s actual return may be

much higher than its expected return and in some years much lower. Over a
long period, however, the average return should be close to the expected return.
Different assets have different expected returns. Table 5.8, for example, shows
that while the expected real return of a U.S. Treasury bill has been less than 1
percent, the expected real return on a group of representative stocks on the New
York Stock Exchange has been more than 9 percent.12 Why would anyone buy
a Treasury bill when the expected return on stocks is so much higher? Because
the demand for an asset depends not just on its expected return, but also on its
risk: Although stocks have a higher expected return than Treasury bills, they
also carry much more risk. One measure of risk, the standard deviation of the
real annual return, is equal to 20.4 percent for common stocks, 8.3 percent for
corporate bonds, and only 3.1 percent for U.S. Treasury bills.
The numbers in Table 5.8 suggest that the higher the expected return on an
investment, the greater the risk involved. Assuming that one’s investments are
well diversified, this is indeed the case.13 As a result, the risk-averse investor
must balance expected return against risk. We examine this trade-off in more
detail in the next section.

11

The price of a bond often changes during the course of a year. If the bond appreciates (or depreciates) in value during the year, its return will be greater (or less) than 10 percent. In addition, the
definition of return given above should not be confused with the “internal rate of return,” which
is sometimes used to compare monetary flows occurring over a period of time. We discuss other
return measures in Chapter 15, when we deal with present discounted values.
12

For some stocks, the expected return is higher, and for some it is lower. Stocks of smaller companies (e.g., some of those traded on the NASDAQ) have higher expected rates of return—and higher
return standard deviations.
13
It is nondiversifiable risk that matters. An individual stock may be very risky but still have a low

expected return because most of the risk could be diversified away by holding a large number of
such stocks. Nondiversifiable risk, which arises from the fact that individual stock prices are correlated
with the overall stock market, is the risk that remains even if one holds a diversified portfolio of
stocks. We discuss this point in detail in the context of the capital asset pricing model in Chapter 15.