Investment Planning:

1
Chapter 11

• Investment Planning
• Reducing Risk of Stock

2
Risk and Return
Commodities and Financial Futures
Precious Metals
Options
R e t u r n
Real Estate
Common Stock
Bonds
3-yr Treasury Notes
U.S. Treasury Bills
Risk
3
Dow Jones Industrial Index
3/26/08
4
Greatest Dollar Gains
2/23/2009
http//www.mdleasing.com/djia-losses.htm
5
Greatest Percentage Gain
2/23/2009
6
Greatest Dollar Loss
2/23/2009
7
Greatest Percentage Losses
2/23/2009
8
History of the Dow
http//finance.yahoo.com/q/bc?sDJItmylonzm
qlc
http//finance.yahoo.com/q/bc?sDJItmylonzm
qlc
9
5-year History of the Dow
http//finance.yahoo.com/q/bc?sDJIt5ylonzm
qlc
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DJIA Last 6 Months
11
A 1 Investment in Different Types ofPortfolios
1926-1996
Index ()
Small Company Stocks
4,495.99
1,370.95
Long-Term Government Bonds
Large Company Stocks
33.73
13.54
8.85
Inflation
Treasury Bills
Year-End
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A 1 Investment in Different Types of Portfolios
1926-2003
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Holding Period Returns
Example Buy 100 shares of ABC for 36/share.
During the year ABC pays a 1.20 dividend and its
price at the end of the year is 42.
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Holding Period Returns
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Annual Return
Annual Return HPR x 365/N
AR 20 x 365/30 243 AR 20 x 365/365
20 AR 20 x 365/730 10
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Risks We Face

• Interest rate risk
• Inflation risk
• Business risk
• Financial risk

• Market risk
• Firm-specific risk
• Liquidity risk

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Diversification Reduces Risk!
0.05 0.04 0.03 0.02 0.01 0 -0.01 -0.02 -0.03
0.05 0.04 0.03 0.02 0.01 0 -0.01 -0.02 -0.03 -0.04
-0.05
0.04 0.03 0.02 0.01 0 -0.01 -0.02 -0.03
Portfolio returns50 A and 50 B
Stock A returns
Stock B returns
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Standard Deviations of Annual Portfolio Returns

• ( 3) (2) Ratio of Portfolio
  (1) Average Standard Standard Deviation to
  Number of Stocks Deviation of Annual Standard
  Deviation in Portfolio Portfolio Returns of a
  Single Stock
• 1 49.24 1.00
• 10 23.93 0.49
• 50 20.20 0.41
• 100 19.69 0.40
• 300 19.34 0.39
• 500 19.27 0.39
• 1,000 19.21 0.39
• These figures are from Table 1 in Meir Statman,
  How Many Stocks Make a Diversified Portfolio?
  Journal of Financial and Quantitative Analysis 22
  (September 1987), pp. 35364. They were derived
  from E. J. Elton and M. J. Gruber, Risk
  Reduction and Portfolio Size An Analytic
  Solution, Journal of Business 50 (October 1977),
  pp. 41537.

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Portfolio Diversification
Average annualstandard deviation ()
49.2
Diversifiable risk
23.9
19.2
Non-diversifiable risk
Number of stocksin portfolio
1
10
20
30
40
1000
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Reduction of Risk Over Time
Holding Periods
Range of Outcomes
150
1 year
100
5 year
50
20 year
10.7
12.6
0
-50
Large company stocks
Small company stocks
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What we know so far.

• Stocks have higher risks and higher returns than
  bonds.
• The higher the risk, the higher the return the
  investor should expect.
• There are many sources of risk.
• Portfolio diversification reduces risk but does
  not eliminate it.
• Investing over long time periods reduces risk.

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So What Do We Do?

• Determine risk preference
• Decide on asset allocation
• Create a diversified portfolio
• Hold portfolio for a long time

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Questions?