[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

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INVESTING IN THE NEW ECONOMY
Investors worry about risk. Risk can be reduced by diversification,
that is, by not putting all your eggs in one basket. Dividing
investments among a large number of securities lowers the
risk because the value of some may go up when the value of
others goes down. In spite of the distinct advantages of risk
diversification, many individuals own relatively few securities.
One of the reasons is that it is costly to buy and sell different
stocks. As a result, individuals have increasingly turned to
mutual funds. Mutual funds are financial intermediaries that
buy large numbers of securities. Transactions costs are lowered
because the securities are bought in bulk. But nothing is
free in life. Mutual fund managers have to make a living, and
they too charge transaction fees. These costs are substantially
lower than if the individual tried to buy an equally diversified
portfolio on her own, but they can be considerable nonetheless.
Mutual funds have significant tax disadvantages as well.
For instance, say you buy shares in a mutual fund in January
2000. In February 2000, the mutual fund sells some shares that
it purchased ten years ago, and records a large capital gain.
Then the value of the fund decreases—perhaps because it was
a high-technology fund, and technology shares plummeted in
April 2000. At the end of the year you may think you have
incurred a loss. But the IRS will still insist you pay a tax as if you
had a capital gain, because you owned shares in the mutual
fund at the time the capital gain was realized. This may seem
grossly unfair—you are worse off, yet you have to pay a tax as
if you were better off—but that is the way the tax law works.
The new economy has opened up new possibilities for
individuals to diversify without large transaction costs. At
least one new economy firm (FOLIOfn) is offering to allow
investors to trade large numbers of stock for a single monthly
fee, with no marginal costs. This arrangement enables individuals
to obtain a highly diversified portfolio, to avoid the
transaction costs of mutual funds, and to avoid the tax disadvantages
of mutual funds. Like all innovations, it will take
time for it to penetrate throughout the economy; but if successful,
it may revolutionize how individuals—especially small
investors—invest their money.
a one-in-two chance (a 50 percent probability) the return will be 5 percent, and
a one-in-four chance (a 25 percent probability) the return will be zero, the expected
return on the stock is 7.5 percent (.25 × 20 percent + .5 × 5 percent + .25 ×
0 percent).
Case in Point
PG&E EMPLOYEES LEARN WHY
DIVERSIFICATION IS IMPORTANT
In January 2001, Pacific Gas & Electric Company (PG&E), a major supplier of electricity
to northern California, quite suddenly found itself facing bankruptcy. Under
California’s utility deregulation statutes, PG&E was prohibited from raising its prices
to consumers but had to pay market prices for the electricity it purchased to deliver
to them. When skyrocketing demand and energy shortages in the West led to record
energy prices, PG&E quickly ran out of cash. Wall Street was equally quick to
respond. PG&E’s stock price plummeted from $31.64 on September 11, 2000, to
872 ∂ CHAPTER 39 A STUDENT’S GUIDE TO INVESTING