Daniel l. Rubinfeld

1172 Part 2 Producers, Consumers, and Competitive Markets
Investor A is quite risk averse, Because his indifference curve U,\ is tangent to
the budget line at a point of lovv risk, he 'will invest almost all his funds in
Treasury bills and earn an expected return R,\ just slightly larger than the riskfree
return R , I
Investor B is less risk averse, She will invest most of her funds in
stocks, and \vhile the return on her portfolio vvill have a higher expected value
R , B
it will also have a higher standard deviation (TB'
1£ Investor B has a sufficiently low level of risk aversion, she might buy stocks
on lllllrgill: that is, she would borrow money from a brokerage firm in order to
invest more than she achlally owns in the stock market In effect, a person who
buys stocks on maro-in hold; a portfolio with more than 100 percent of the port-
, 0
folio's value invested in stocks, This situation is illustrated in Figure 5,8, which
sho\'vs indifference curves for two investors, Investor A, who is relatively riskaverse,
invests about half of his funds in stocks. Investor B, however, has an indifference
curve that is relatively nat and tangent with the budget line at a point
where the expected return on the portfolio exceeds the expected return on the
stock market In order to hold this portfolio, the investor must borrow money
because she wants to invest lllorc than 100 percent of her \'\'ealth in the stock market
Buying stocks on margin in this vvay is a form of lcvcrngc: the investor increases
her expected return above that for the overall stock market, but at the cost of
increased risk.
Md
Budget
Line
In Chapters 3 and 4, we simplified the problem of consumer choice by assuminO'
that the consumer had only two goods from which to choose-food and
c1;thing. In the same spirit, we have simplified the investor's choice by limiting
it to Treasury bills and stocks. The basic principles, howe\'er, would be the same
if we had more assets (e,g" corporate bonds, land, and different types of stocks),
Every il1\'estor faces a trade-off between risk and return F The degree of extra
risk that each is willing to bear in order to earn a higher expected return depends
on hoW risk a\'erse he or she is, Less risk-averse im'estors tend to include a
larger fraction of risky assets in their portfolios.
During the 1990s, we witnessed a shift in the investing behavior of
Americans, First, manv _ Americans started investirw 0 in the stock market
for the first time, In 1989, about 32 percent of families in the United States had
part of their wealth im'ested in the stock market, either directly (by owning
individual stocks) or indirectly (through mutual funds or pension plans
invested in stocks). By 1995, that traction had risen to above ,n percent In addition,
the share of wealth invested in stocks increased from about 26 percent to
about 40 percent during this period,18
Much of this shift is attributable to younger ilwestors, For those under the
age of 35, participation in the stock market increased from about 23 percent in
1989 to about 39 percent in 1995. For those older than 35, participation also
increased, though by much less,
Wlw have more people, and especially vourwer neople started investino- in
p • w b rIb
the stock market One reason is the ad,'ent of on-line tradino- over the Internet
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'
which has made investing much easier. Another reason may be the considerable
increase in stock prices that occurred during the late 1990s. These increases
may ha\'e convinced some investors that prices could only continue to rise in
the fuhue, As one analyst has put it, "The market's relentl~ss se\'en-year climb,
the popularity of mutual funds, the shift by employers to self-dire~ted retirement
plans, and the avalanche of do-it-yourself investment publications all
have combined to create a nation of financial know-it-alls,"l"
The run-up in the stock market during the 1990s has indeed surprised many
people. Although the American economy has been very strong over this period,
by 1999 prices reached almost unprecedented levels relative to earninas and
dividends. Figure 5.9 shmvs the dividend vield and price/earnino-s ratio for the
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S&P 500 (an index of the stocks of 500 large corporations) OWl' the period 1980-
1999, Observe that the dividend yield (the annual dividend di"ided by the
stock price) fell from about 5 percent in 1980 to about 15 percent in 1999~ The
5 Choice Under Uncertainty 173
Because Investor A is risk averse, his portfolio contains a mixture of stocks and riskfree
Treasury bills. Investor B, however, has a very low degree of risk aversion. Her
indifference curve, UB' is tangent to the budget line at a point where the expected
return and standard deviation for her portfolio exceed those for the stock market
overall. TIus implies that she would like to invest marc than 100 percent of her wealth
in the stock market. She does so buying stocks all IlIllrgin-i.e., by borrowing from
. As mentioned earlier, what matters is nondi\'ersifiable risk, because im'estors can eliminate di\'erslhable
risk by holding many different stocks (eg, \'ia mutual funds) We discuss di\'ersifiable \'er­
~~s nondi\'ersifiable risk in Chapter IS
. Data are tram the Fcdewi Rcscn'c Blilletill. Januan' 1997
l~ "v i ' .
\e r.e :\Il Bulls Here: Strong :Vlarket :V'lakes E\'er\'C'od\' an Exnert " WillI Street JOllnllli September
12,1997 c •• r' '