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Investment Planning: Reducing Risk of Stock

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Investment Planning: Reducing Risk of Stock

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    1. Chapter 11 Investment Planning: Reducing Risk of Stock

    2. Risk and Return

    3. Dow Jones Industrial Index

    4. Greatest Dollar Gains

    5. Greatest Percentage Gain

    6. Greatest Dollar Loss

    7. Greatest Percentage Losses

    8. History of the Dow

    9. 5-year History of the Dow

    10. DJIA Last 6 Months

    11. A $1 Investment in Different Types of Portfolios: 1926-1996

    12. A $1 Investment in Different Types of Portfolios: 1926-2003

    13. Holding Period Returns

    14. Holding Period Returns

    15. Annual Return

    16. Risks We Face Interest rate risk Inflation risk Business risk Financial risk Market risk Firm-specific risk Liquidity risk

    17. Diversification Reduces Risk!

    18. 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. 353–64. 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. 415–37.

    19. Portfolio Diversification

    20. Reduction of Risk Over Time

    21. 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.

    22. So What Do We Do? Determine risk preference Decide on asset allocation Create a diversified portfolio Hold portfolio for a long time

    23. Questions?

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