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Unformatted text preview: Ch. 8 A New Walking Shoe: Modern Portfolio Theory (MPT)new investment technology = academic & followed by streetMPT = reduce risk while possibly earning a higher return Role of Risk EMT explains why random walk = possiblestock market = so good at adjusting to new info that no one can predict its fut. course in a sup. mannerb/c of action of pros, prices of indiv. stocks quickly reflect all available newsevens 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 Returnsinvestment risk = chance that expected security returns (incl. dividends) will not materialize & stock will fall in pricefinancial risk = variance or standard deviation of returnsavg./expected returns = little or no risk & volatile returns (losses in some years) = risky Expected Return & Variance Measures of Reward & Riskvariance = measure of dispersion of returns avg. squared deviation of each possible return from its avg./expected valuestandard deviation = square root of the variancerisk=possibility of downward disappointmentsas 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 measurethe greater the dispersion or variance measure, the greater the possibilities for disappointmentpattern of historical returns from individual securities = not usually been symmetricreturns from welldiversified portfolios of stocks = at least roughly symmetricalreasonably 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 deviationsthe higher the standard deviation (more spread out returns), the greater the risk Documenting Risk: A LongRun Studybestdocumented position in finance = on avg., investors have received higher rates of return for bearing greater riskover long periods of time, common stocks have, on avg., provided relatively generous total rates of returnthese returns (dividends & capital gains) have exceeded by a substantial margin the returns from longterm bonds, Treasury bills, & inflation ratestocks provide positive real rates of return (after taking out inflation)common stocks = highly variableextra returns come at expense of assuming considerably higher risksmallcompany 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 riskaverse want high returns & guaranteed outcomescombining stocks to give them least risk possible, consistent w/ return they seekgives a rigorous mathematical justification for the timehonored 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
 Petersen

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