178 PART • 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 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 percent, our bond, apartment building, and share of GM stock have yielded real returns of 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 percent, the expected real return on a group of representative stocks on the New York Stock Exchange has been more than 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