Investments and the Industry

1. Define special or abnormal returns?

Special or abnormal returns refer to gains beyond what the market would normally provide after adjustment for risk. This is also referred to as an anomaly. Generally speaking abnormal returns is the difference between the actual return and that is expected to result from market movements (normal return). This can also be positive or negative. If the return for a specific investment is 5% yet the security has a return of 3% this would be an example of a negative “abnormal” return.

2. What does Table 9–5 on page 252 indicate about the relationship between a firm’s P/E ratio and its average quarterly return?

What this chart is showing is that there is a distinctive relationship between the average P/E ratio and the average quarterly risk adjusted return. The risk-adjusted return of an asset or a portfolio is the return it provides adjusted for how risky it is. The table shows data from the electronics industry however similar patterns have been found in other industries. The studies show the lower the average P/E ratio the higher the risk-adjusted return. This could be a result of the “size” effect or “industry” effect. Therefore, when P/E ratios imply stocks are undervalued, stocks seem to largely outperform bonds on both an absolute (higher returns) and risk-adjusted basis (return relative to standard deviation), and they do so by a larger amount than they do on average.

3. If you “buy straw hats in winter” or buy “when there is blood in the street,” what kind of investor are you?

You would be a “contrarian investor”. Investors often become fearful when markets collapse, but a contrarian looks at a market collapse as a buying opportunity. This is a fundamental concept of investing and can be used to your benefit if used properly. Many times investors who stick to dollar cost averaging or just simply making monthly contributions sometimes invest when others may be panicking or selling. But true...