TAILIEUCHUNG - Fundamentals of Financial Management (2003) Chapter 6-11

If some one had incested $1,000 in a portfolio of large - company stocks in 1925 and then reinvested all dividents received, his or her invested would have grown to $2,845,697 by 1990. Over the same time period, a portfolio of small -company stocks would have grown even more, to $6,641,505. | FUNDAMENTALS OF FINANCIAL MANAGEMENT BRIGHAM HOUSTON CHAPTER 6 Risk and Rates of Return SOURCE Beard William Holbrook 1823-1900 . New York Historical Society The Bridgeman Art Library International Ltd. 3 0 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 2 845 697 by 1999. Over the same time period a portfolio of small-company stocks would have grown even more to 6 641 505. But if instead he or she had invested in long-term government bonds the 1 000 would have grown to only 40 219 and to a measly 15 642 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 74 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 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 stocC or ind ustry. . . . Correlation i n 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. . investors tend to think of the stock market as the . stock market. However

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