The Dryden Press: Finance: Brigham

ISBN: 0-03-028931-9

Chapter 6 Risk and Rates of Return

No Pain, No Gain

If someone had invested $1,000 in a portfolio of large-company stocks in 1925 and then reinvested all dividends received, his or her investment would have grown to $2,351,000 by 1998. Over the same time period, a portfolio of small-company stocks would have grown even more, to $5,117,000. But if instead he or she had invested in long-term government bonds, the $1,000 would have grown to only $34,000, and to a measly $15,000 for short-term bonds.
Given these numbers, why would anyone invest in bonds? The answer is, "Because bonds are less risky." While common stocks have over the past 73 years produced considerably higher returns, (1) we cannot be sure that the past is a prologue to the future, and (2) stock values are more likely to experience sharp declines than bonds, so one has a greater chance of losing money on a stock investment. For example, in 1990 the average small-company stock lost 21.6 percent of its value, and large-company stocks also suffered losses. Bonds, though, provided positive returns that year, as they almost always do.
Of course, some stocks are riskier than others, and even in years when the overall stock market goes up, many individual stocks go down. Therefore, putting all your money into one stock is extremely risky. According to a Business Week article, the single best weapon against risk is diversification: "By spreading your money around, you're not tied to the fickleness of a given market, stock, or industry. . . . Correlation, in portfolio-manager speak, helps you diversify properly because it describes how closely two investments track each other. If they move in tandem, they're likely to suffer from the same bad news. So, you should combine assets with low correlations."
U.S. investors tend to think of "the stock market" as the U.S. stock market. However, U.S. stocks amount to only 35 percent of the value of all stocks. Foreign markets have been quite profitable, and they are not perfectly correlated with U.S. markets. Therefore, global diversification offers U.S. investors an opportunity to raise returns and at the same time reduce risk. However, foreign investing brings some risks of its own, most notably "exchange rate risk," which is the danger that exchange rate shifts will decrease the number of dollars a foreign currency will buy.
Although the central thrust of the Business Week article was on ways to measure and then reduce risk, it did point out that some recently created instruments that are actually extremely risky have been marketed as low-risk investments to naive investors. For example, several mutual funds have advertised that their portfolios "contain only securities backed by the U.S. government" but then failed to highlight that the funds themselves are using financial leverage, are investing in "derivatives," or are taking some other action that boosts current yields but exposes investors to huge risks.
When you finish this chapter, you should understand what risk is, how it is measured, and what actions can be taken to minimize it, or at least to ensure that you are adequately compensated for bearing it.

DISCUSSION QUESTIONS

In the vignette, it is stated that, historically, small-company stocks have provided the largest returns, followed by large-company stocks, long-term government bonds, and short-term government bonds. On that basis, what conclusion would you expect to draw about the relative total risks of these types of investments? In other words, which securities would you expect to have the highest and lowest total risks?
Because an investment carries a great deal of risk, does that mean that a rational investor should seek to avoid having this investment as part of his/her overall portfolio?
Can you think of any reason why a rational investor would want to hold an asset with high risk, and little (if not negative) return?
What factor would likely dictate any of your investing decisions, higher return or lower risk? In other words, to what extent do you think you are risk averse? Would you ever hold an asset that had a negative return?

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