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Allocation of Risk
Virtually all real assets involve some risk. When GM builds its auto plants, for example, it
cannot know for sure what cash flows those plants will generate. Financial markets and the di-
verse financial instruments traded in those markets allow investors with the greatest taste for
risk to bear that risk, while other, less risk-tolerant individuals can, to a greater extent, stay on
the sidelines. For example, if GM raises the funds to build its auto plant by selling both stocks
and bonds to the public, the more optimistic or risk-tolerant investors can buy shares of stock
in GM, while the more conservative ones can buy GM bonds. Because the bonds promise to
provide a fixed payment, the stockholders bear most of the business risk. Thus, capital mar-
kets allow the risk that is inherent to all investments to be borne by the investors most willing
to bear that risk.
This allocation of risk also benefits the firms that need to raise capital to finance their in-
vestments. When investors are able to select security types with the risk-return characteristics
that best suit their preferences, each security can be sold for the best possible price. This fa-
cilitates the process of building the economy™s stock of real assets.

Separation of Ownership and Management
Many businesses are owned and managed by the same individual. This simple organization is
well-suited to small businesses and, in fact, was the most common form of business organiza-
tion before the Industrial Revolution. Today, however, with global markets and large-scale
production, the size and capital requirements of firms have skyrocketed. For example, General
Electric has property, plant, and equipment worth over $40 billion, and total assets in excess
of $400 billion. Corporations of such size simply cannot exist as owner-operated firms. GE ac-
tually has over one-half million stockholders with an ownership stake in the firm proportional
to their holdings of shares.
Such a large group of individuals obviously cannot actively participate in the day-to-day
management of the firm. Instead, they elect a board of directors which in turn hires and su-
pervises the management of the firm. This structure means that the owners and managers of
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Essentials of Investments, Background and Issues Companies, 2003
Fifth Edition

8 Part ONE Elements of Investments

the firm are different parties. This gives the firm a stability that the owner-managed firm can-
not achieve. For example, if some stockholders decide they no longer wish to hold shares in
the firm, they can sell their shares to another investor, with no impact on the management of
the firm. Thus, financial assets and the ability to buy and sell those assets in the financial mar-
kets allow for easy separation of ownership and management.
How can all of the disparate owners of the firm, ranging from large pension funds holding
hundreds of thousands of shares to small investors who may hold only a single share, agree on
the objectives of the firm? Again, the financial markets provide some guidance. All may agree
that the firm™s management should pursue strategies that enhance the value of their shares.
Such policies will make all shareholders wealthier and allow them all to better pursue their
personal goals, whatever those goals might be.
Do managers really attempt to maximize firm value? It is easy to see how they might be
tempted to engage in activities not in the best interest of shareholders. For example, they might
engage in empire building or avoid risky projects to protect their own jobs or overconsume lux-
uries such as corporate jets, reasoning that the cost of such perquisites is largely borne by the
agency problem shareholders. These potential conflicts of interest are called agency problems because man-
agers, who are hired as agents of the shareholders, may pursue their own interests instead.
Conflicts of interest
Several mechanisms have evolved to mitigate potential agency problems. First, compensa-
between managers
tion plans tie the income of managers to the success of the firm. A major part of the total com-
and stockholders.
pensation of top executives is typically in the form of stock options, which means that the
managers will not do well unless the stock price increases, benefiting shareholders. (Of
course, we™ve learned more recently that overuse of options can create its own agency prob-
lem. Options can create an incentive for managers to manipulate information to prop up a
stock price temporarily, giving them a chance to cash out before the price returns to a level re-
flective of the firm™s true prospects.) Second, while boards of directors are sometimes por-
trayed as defenders of top management, they can, and in recent years increasingly do, force
out management teams that are underperforming. Third, outsiders such as security analysts
and large institutional investors such as pension funds monitor the firm closely and make the
life of poor performers at the least uncomfortable.
Finally, bad performers are subject to the threat of takeover. If the board of directors is lax
in monitoring management, unhappy shareholders in principle can elect a different board.
They can do this by launching a proxy contest in which they seek to obtain enough proxies
(i.e., rights to vote the shares of other shareholders) to take control of the firm and vote in an-
other board. However, this threat is usually minimal. Shareholders who attempt such a fight
have to use their own funds, while management can defend itself using corporate coffers.
Most proxy fights fail. The real takeover threat is from other firms. If one firm observes an-
other underperforming, it can acquire the underperforming business and replace management
with its own team.

asset allocation
An investor™s portfolio is simply his collection of investment assets. Once the portfolio is es-
Allocation of an
tablished, it is updated or “rebalanced” by selling existing securities and using the proceeds to
investment portfolio
buy new securities, by investing additional funds to increase the overall size of the portfolio,
across broad asset
or by selling securities to decrease the size of the portfolio.
Investment assets can be categorized into broad asset classes, such as stocks, bonds, real
estate, commodities, and so on. Investors make two types of decisions in constructing their
security selection
portfolios. The asset allocation decision is the choice among these broad asset classes, while
Choice of specific
the security selection decision is the choice of which particular securities to hold within each
securities within each
asset class.
asset class.
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Essentials of Investments, Background and Issues Companies, 2003
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1 Investments: Background and Issues

“Top-down” portfolio construction starts with asset allocation. For example, an individual
who currently holds all of his money in a bank account would first decide what proportion of
the overall portfolio ought to be moved into stocks, bonds, and so on. In this way, the broad
features of the portfolio are established. For example, while the average annual return on the
common stock of large firms since 1926 has been about 12% per year, the average return on
U.S. Treasury bills has been only 3.8%. On the other hand, stocks are far riskier, with annual
returns that have ranged as low as 46% and as high as 55%. In contrast, T-bill returns are ef-
fectively risk-free: you know what interest rate you will earn when you buy the bills. There-
fore, the decision to allocate your investments to the stock market or to the money market
where Treasury bills are traded will have great ramifications for both the risk and the return of
your portfolio. A top-down investor first makes this and other crucial asset allocation decisions
before turning to the decision of the particular securities to be held in each asset class.
Security analysis involves the valuation of particular securities that might be included in security analysis
the portfolio. For example, an investor might ask whether Merck or Pfizer is more attractively Analysis of the value
priced. Both bonds and stocks must be evaluated for investment attractiveness, but valuation of securities.
is far more difficult for stocks because a stock™s performance usually is far more sensitive to
the condition of the issuing firm.
In contrast to top-down portfolio management is the “bottom-up” strategy. In this process,
the portfolio is constructed from the securities that seem attractively priced without as much
concern for the resultant asset allocation. Such a technique can result in unintended bets on
one or another sector of the economy. For example, it might turn out that the portfolio ends up
with a very heavy representation of firms in one industry, from one part of the country, or with
exposure to one source of uncertainty. However, a bottom-up strategy does focus the portfo-
lio on the assets that seem to offer the most attractive investment opportunities.

Financial markets are highly competitive. Thousands of intelligent and well-backed analysts
constantly scour the securities markets searching for the best buys. This competition means
that we should expect to find few, if any, “free lunches,” securities that are so underpriced that
they represent obvious bargains. There are several implications of this no-free-lunch proposi-
tion. Let™s examine two.

The Risk-Return Trade-Off
Investors invest for anticipated future returns, but those returns rarely can be predicted precisely.
There will almost always be risk associated with investments. Actual or realized returns will al-
most always deviate from the expected return anticipated at the start of the investment period.
For example, in 1931 (the worst calendar year for the market since 1926), the stock market lost
43% of its value. In 1933 (the best year), the stock market gained 54%. You can be sure that in-
vestors did not anticipate such extreme performance at the start of either of these years.
Naturally, if all else could be held equal, investors would prefer investments with the highest
expected return.2 However, the no-free-lunch rule tells us that all else cannot be held equal. If
you want higher expected returns, you will have to pay a price in terms of accepting higher in-
vestment risk. If higher expected return can be achieved without bearing extra risk, there will be

The “expected” return is not the return investors believe they necessarily will earn, or even their most likely return.
It is instead the result of averaging across all possible outcomes, recognizing that some outcomes are more likely than
others. It is the average rate of return across possible economic scenarios.
Bodie’Kane’Marcus: I. Elements of Investments 1. Investments: © The McGraw’Hill
Essentials of Investments, Background and Issues Companies, 2003
Fifth Edition

10 Part ONE Elements of Investments

a rush to buy the high-return assets, with the result that their prices will be driven up. Individu-
als considering investing in the asset at the now-higher price will find the investment less at-
tractive: If you buy at a higher price, your expected rate of return (that is, profit per dollar
invested) is lower. The asset will be considered attractive and its price will continue to rise until
its expected return is no more than commensurate with risk. At this point, investors can antici-
pate a “fair” return relative to the asset™s risk, but no more. Similarly, if returns are independent
of risk, there will be a rush to sell high-risk assets. Their prices will fall (and their expected fu-
ture rates of return will rise) until they eventually become attractive enough to be included again
risk-return in investor portfolios. We conclude that there should be a risk-return trade-off in the securities
trade-off markets, with higher-risk assets priced to offer higher expected returns than lower-risk assets.
Of course, this discussion leaves several important questions unanswered. How should one
Assets with higher
measure the risk of an asset? What should be the quantitative trade-off between risk (properly
expected returns have
measured) and expected return? One would think that risk would have something to do with
greater risk.
the volatility of an asset™s returns, but this guess turns out to be only partly correct. When we
mix assets into diversified portfolios, we need to consider the interplay among assets and the
effect of diversification on the risk of the entire portfolio. Diversification means that many as-
sets are held in the portfolio so that the exposure to any particular asset is limited. The effect
of diversification on portfolio risk, the implications for the proper measurement of risk, and
the risk-return relationship are the topics of Part Two. These topics are the subject of what has
come to be known as modern portfolio theory. The development of this theory brought two of
its pioneers, Harry Markowitz and William Sharpe, Nobel Prizes.

Efficient Markets
Another implication of the no-free-lunch proposition is that we should rarely expect to find
bargains in the security markets. We will spend all of Chapter 8 examining the theory and ev-
idence concerning the hypothesis that financial markets process all relevant information about
securities quickly and efficiently, that is, that the security price usually reflects all the infor-
mation available to investors concerning the value of the security. According to this hypothe-
sis, as new information about a security becomes available, the price of the security quickly
adjusts so that at any time, the security price equals the market consensus estimate of the value
of the security. If this were so, there would be neither underpriced nor overpriced securities.
One interesting implication of this “efficient market hypothesis” concerns the choice be-
tween active and passive investment-management strategies. Passive management calls for
holding highly diversified portfolios without spending effort or other resources attempting to
improve investment performance through security analysis. Active management is the at-
Buying and holding a
tempt to improve performance either by identifying mispriced securities or by timing the per-
diversified portfolio
formance of broad asset classes”for example, increasing one™s commitment to stocks when
without attempting to
identify mispriced one is bullish on the stock market. If markets are efficient and prices reflect all relevant infor-
securities. mation, perhaps it is better to follow passive strategies instead of spending resources in a futile
attempt to outguess your competitors in the financial markets.
active If the efficient market hypothesis were taken to the extreme, there would be no point in
management active security analysis; only fools would commit resources to actively analyze securities.
Without ongoing security analysis, however, prices eventually would depart from “correct”
Attempting to identify
mispriced securities values, creating new incentives for experts to move in. Therefore, even in environments as
or to forecast broad competitive as the financial markets, we may observe only near-efficiency, and profit op-
market trends.
portunities may exist for especially diligent and creative investors. This motivates our dis-
cussion of active portfolio management in Part Six. More importantly, our discussions of
security analysis and portfolio construction generally must account for the likelihood of
nearly efficient markets.
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Essentials of Investments, Background and Issues Companies, 2003
Fifth Edition

1 Investments: Background and Issues

From a bird™s-eye view, there would appear to be three major players in the financial markets:
1. Firms are net borrowers. They raise capital now to pay for investments in plant and
equipment. The income generated by those real assets provides the returns to investors
who purchase the securities issued by the firm.
2. Households typically are net savers. They purchase the securities issued by firms that
need to raise funds.
3. Governments can be borrowers or lenders, depending on the relationship between tax
revenue and government expenditures. Since World War II, the U.S. government
typically has run budget deficits, meaning that its tax receipts have been less than its
expenditures. The government, therefore, has had to borrow funds to cover its budget
deficit. Issuance of Treasury bills, notes, and bonds is the major way that the government
borrows funds from the public. In contrast, in the latter part of the 1990s, the government
enjoyed a budget surplus and was able to retire some outstanding debt.
Corporations and governments do not sell all or even most of their securities directly to in-
dividuals. For example, about half of all stock is held by large financial institutions such as
pension funds, mutual funds, insurance companies, and banks. These financial institutions
stand between the security issuer (the firm) and the ultimate owner of the security (the indi-
vidual investor). For this reason, they are called financial intermediaries. Similarly, corpora-
tions do not market their own securities to the public. Instead, they hire agents, called
investment bankers, to represent them to the investing public. Let™s examine the roles of these

Financial Intermediaries
Households want desirable investments for their savings, yet the small (financial) size of most


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