David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 12 Risk and information
0 Why such wild swings? Largely because the market is having to extrapolate current information to make guesses
about the entire stream of future earnings of these companies. In volatile sectors, small changes in current
information can lead to rapid reassessments about future earnings. Since the share price embodies the future
earnings that a company will earn, share prices can change dramatically when uncertainty about a sector is great.
D FTSE 1 O; Lost: 5 03, Hi: 6
©cO=iito=IFLoo=k--+---+---+---+---+--++ 7000
>----+--+------- 3000
1996 1998 2000 2002 2004 2006 2008 2010
Source: http://www.moneyweek.com.
Shares are riskier for two reasons. First, nobody is sure what dividend the firm will pay. It depends what
profit the firm makes and how confident it is about the future. When firms anticipate tough times, they cut
dividends in order to keep a contingency reserve within the firm.
Second, views about the likely capital gains change radically. Stock market investors paid high prices for
dotcom companies in the late 1990s, even though profits were still years away. People thought the present
value of distant dividends was big. Discounting reduces the value of future dividends, but people were
projecting spectacular growth and eventually huge dividends. Growth projections were slashed as reality
crept in, and estimated present values changed a lot. Share prices in Amazon and Yahoo! fell by 80 per cent
or more during 2000-01. Case 12.3 gives details over a longer period. Thus, revisions in belief about capital
gains are what cause volatile share prices and share returns .
f'il Portfolio selection
._,_ _ _ _ _
The portfolio of a financial investor is the bundle of financial and real assets - bank deposits, Treasury bills,
government bonds, shares in industrial companies, gold, works of art - in which wealth is held. How does
a risk-averse investor select his portfolio or wealth composition?
Chapter 5 set out the basic model of consumer choice. The budget line summarized the market opportunities
- the goods that a given income would buy. Indifference curves showed individual tastes, and the consumer
chose the bundle on the highest possible indifference curve given the budget constraint describing which
bundles were affordable.
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