covariances between the individual securities than on the variances of the

Covariances between the individual securities than on

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covariances between the individual securities than on the variances of the individual securities. 11.6 Diversification So far, in this chapter we have examined how the risks and returns of individual assets impact the risk and return of the portfolio. We also touched on one aspect of this impact, diversification. To give a recent example, the Dow Jones Industrial Average (DJIA), which contains 30 large, well-known U.S. stocks, rose about 6.5 percent in 2007, an increase somewhat below historical standards. The biggest individual gainers in that year were Honeywell International (up 36%), Merck (up 33%), and McDonald’s (up 33%), while the biggest losers were Citigroup (down 47%), Home Depot (down 33%), and General Motors (down 19%). As can be seen, variation among these individual stocks was reduced through diversification. While this example shows that diversification is good we now want to examine it is good. And just how good is it? We begin the discussion of diversification by focusing on the stock of one company, which we will call Flyers. What will determine this stock’s return in, say, the coming month? The return on any stock consists of two parts. First, the or from the stock is the part of the return that shareholders in the market predict or expect. It depends on all of the information shareholders have that bears on the stock, and it uses all of our understanding of what will influence the stock in the next month. The second part is the or on the stock. This is the portion that comes from information that will be revealed within the month. The list of such information is endless, but here are some examples: News about Flyers’ research. Government figures released for the gross national product (GNP). Results of the latest arms control talks. Discovery that a rival’s product has been tampered with. News that Flyers’ sales figures are higher than expected.
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A sudden drop in interest rates. The unexpected retirement of Flyers’ founder and president. A way to write the return on Flyers’ stock in the coming month, then, is: where is the actual total return in the month, is the expected part of the return, and stands for the unexpected part of the return. The unanticipated part of the return—that portion resulting from surprises—is the true risk of any investment. After all, if we got what we had expected, there would be no risk and no uncertainty. There are important differences, though, among various sources of risk. Look at our previous list of news stories. Some of these stories are directed specifically at Flyers, and some are more general. Which of the news items are of specific importance to Flyers? Announcements about interest rates or GNP are clearly important for nearly all companies, whereas the news about Flyers’ president, its research, its sales, or the affairs of a rival company are of specific interest to Flyers. We will divide these two types of announcements and the resulting risk, then, into two components: a systematic portion, called , and the remainder, which we call or . The following definitions describe the difference:
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