Thursday 618

Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed.

PART 9 The Real Economy in the Long Run

Chapter 27 of 36 Basic Tools of Finance

Section 8 of 15

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Figure 2 – Diversification Reduces Risk

This figure shows how the risk of a portfolio depends on the number of stocks in the investor’s portfolio.

The investor is assumed to own equal percentage of each stock.

Increasing the number of different company stocks owned reduces stock portfolio risk.

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Here we consider three aspects of risk aversion.

1· insurance markets

2· diversification

3· risk-return trade-off

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2-Diversification

Enron, a large and respected company, in 2002 went bankrupt amid accusations of accounting fraud.

Several company top executives were prosecuted and sent to prison.

Thousands of Enron employees lost their jobs and many lost their entire life savings.

The employees typically had two-thirds of their retirement fund invested in Enron stock, which became worthless.

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A person who buys stock in a company is betting on the future prospects of that company.

The bet is risky because companies' futures cannot be predicted.

Microsoft evolved from a start-up by teenagers to one of the world's biggest companies in a few years.

Enron went from being one of the most respected companies to a worthless one in a few months.

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A stock market investor need not tie his own fortune to any single company.

Figure 2 shows how the risk of a portfolio of stocks depends on the portfolio’s number of stocks.

Risk is measured with a statistic called the standard deviation.

The risk of a stock portfolio falls substantially as the number of stocks increases.

Going from 1 stock to 10 stocks reduces the risk by about half.

Going from 10 to 20 stocks reduces the risk by about another 10%.

Risk reduction after 20 stocks is small.

One can buy shares in the exchange traded fund (ETF) SPY which contains shares of all of the Standard & Poor’s 500 companies.

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The remaining risk is the risk the entire stock market value might fall.

Diversification minimizes firm-specific risk but cannot eliminate market risk, the uncertainty associated with the entire economy.

When the economy goes into recession most companies experience falling sales and reduced profit, with resulting falling stock prices.

It is said, “the stock market is an up and down roller coaster ride.”

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ChatGPT: “In the United States, the S&P 500 index has delivered an average annual return of around 10% over the past 90 years, adjusting for inflation.”

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a statistic called standard deviation

hyōjun hensa to yoba reru tōkei-ryō

標準偏差と呼ばれる統計量

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If a person randomly picks and invests in one stock, what are the chances over time it will go up close to the overall market rate? ChatGPT:

Surprisingly, the odds are lower than most people think.

The market is capitalization-weighted.

A few big winners contribute a huge share of the market's long-run return.

If you randomly pick one stock, you are equally likely to pick a future loser as a future superstar.

Research has found that over long periods:

Many individual stocks underperform the market.

A substantial fraction underperform even Treasury bills.

A relatively small number of huge winners generate a large share of the market's total wealth creation.

Imagine 100 stocks:

10 become enormous winners.

20 do somewhat better than the market.

30 roughly match the market.

40 lag badly or fail.

The market return can still be strong because the big winners become a larger and larger share of the market index.

As a result, a randomly selected stock is more likely to underperform the market than outperform it over a long horizon.

This is one of the strongest arguments for index (e.g. ETF) investing.

Owning the entire market guarantees you own the rare stocks that become the next Microsoft, Apple, Nvidia, or Amazon.

Missing just a few of those winners can dramatically reduce your return.

So if you randomly picked one stock today and held it for 20 years, the probability that it ends up very close to the market return is probably well below 50%.

The probability that a portfolio of 40 randomly chosen stocks ends up reasonably close to the market return is much higher because diversification averages out those company-specific outcomes.