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Unformatted text preview: Ch. 8 A New Walking Shoe: Modern Portfolio Theory (MPT)-new investment technology = academic & followed by street-MPT = reduce risk while possibly earning a higher return Role of Risk EMT explains why random walk = possible-stock market = so good at adjusting to new info that no one can predict its fut. course in a sup. manner-b/c of action of pros, prices of indiv. stocks quickly reflect all available news-evens the odds of selecting sup. stocks or anticipating general market- risk alone determines degree to which returns will be above / below avg. Defining Risk: The Dispersion of Returns-investment risk = chance that expected security returns (incl. dividends) will not materialize & stock will fall in price-financial risk = variance or standard deviation of returns-avg./expected returns = little or no risk & volatile returns (losses in some years) = risky Expected Return & Variance Measures of Reward & Risk-variance = measure of dispersion of returns avg. squared deviation of each possible return from its avg./expected value-standard deviation = square root of the variance-risk=possibility of downward disappointments-as long as the distribution of returns is symmetric (as long as the chances of extraordinary gain are roughly the same as the probabilities for disappoint returns & losses a dispersion or variance measure will suffice as a risk measure-the greater the dispersion or variance measure, the greater the possibilities for disappointment-pattern of historical returns from individual securities = not usually been symmetric-returns from well-diversified portfolios of stocks = at least roughly symmetrical-reasonably symmetric distributions = 2/3s of monthly returns tend to fall w/i one standard deviation of the avg. return & 95% of the returns fall w/i two standard deviations-the higher the standard deviation (more spread out returns), the greater the risk Documenting Risk: A Long-Run Study-best-documented position in finance = on avg., investors have received higher rates of return for bearing greater risk-over long periods of time, common stocks have, on avg., provided relatively generous total rates of return-these returns (dividends & capital gains) have exceeded by a substantial margin the returns from long-term bonds, Treasury bills, & inflation rate-stocks provide positive real rates of return (after taking out inflation)-common stocks = highly variable-extra returns come at expense of assuming considerably higher risk-small-company stocks = higher rate of return but the dispersion (standard dev.) of those returns has been larger than for other stocks Reducing Risk: Modern Portfolio Theory (MPT)-begins w/ premise that all investors are risk-averse want high returns & guaranteed outcomes-combining stocks to give them least risk possible, consistent w/ return they seek-gives a rigorous mathematical justification for the time-honored investment maxim that diversification is a sensible strategy for individuals who like to reduce their risks...
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This note was uploaded on 02/09/2012 for the course ECON 380 taught by Professor Petersen during the Spring '11 term at BC.
- Spring '11