What Are Common Stocks?

What Are Common Stocks?

What Are Common Stocks?

What Are Common Stocks?

Things have proceeded satisfactorily so far. Average rates of returnon low-class bonds have been greater than rates on high-class bonds,and rates on common stocks have on the average generally exceeded rates on bonds. All of this is in accordance with what we would expectin a market dominated by risk-averse investors who expect to receive,and on the average actually receive, superior returns for holding assetof greater riskiness. When we turn to common stocks themselves, theresults are less clear cut and satisfactory.

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Unfortunately, there is no long-established commercial servicewhich provides generally accepted ratings of the riskiness of commonstocks. Investigators have usually provided their own rankings. Letus start with the work of Shannon Pratt.3 Pratt ranked all commonstocks on the New York Stock Exchange according to the variability(standard deviation) of their monthly rates of return during two preceding periods of three and five years. For the three-year periods,Pratt ranked stocks for 372 different dates, beginning in January 31,1929 and ending December 31, 1959. For the five-year periods, therewere 348 periods, beginning in January 31, 1931. He then dividedcommon stocks into quintiles on the basis of their historical variabilityin order to determine the average rate of return for each quintileduring subsequent holding periods of one, three, five, and seven years.

His major finding can be easily summarized. If the first quintile includes the stocks with the least variable returns, the second quintileon the average generally has a higher rate of return than the first,the third generally has a higher return than the second, and the fourthgenerally has a slightly greater return than the third. The performanceof the fifth quintile varies. In some instances, it has a lower rate ofreturn than the fourth and a return not very different from the third.In other words, the relationship between risk as measured by historicvariability and future returns is somewhat as we would expect, butnot completely. Returns generally rise with risk as measured by historicvariability, but at a decelerating rate. And, there is some suggestionthat rates for the most variable quintile are less than for less variablequintiles.

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These results require interpretation or explanation. The results arevaguely disturbing in that they represent a break in the smooth progression from very high-quality bonds with relatively low returns to low-quality bonds, to common stocks, and to common stocks of variousdegrees of riskiness. The fact that average rates of return on stocksof the lowest quality or with the greatest historic variability are lowerthan for stocks of higher quality or with smaller historic variabilitymust be discussed.

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