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

(and in some cases, their parents) for most of their lives. The sudden collapse of
PG&E underscores the importance of diversification to minimize (though not avoid
entirely) the risk of holding individual stocks. 3
An important first lesson in investment theory is as follows: If there were no differences
between assets other than the ways in which they produce returns (interest, dividends,
etc.), then the expected returns to all assets would be the same. Why? Suppose
an asset offered an expected return of 10 percent while all others offered 6 percent.
Investors, in trying to buy the higher-yielding asset, would bid more for it, thereby
pushing up its price. As the price rose, the expected return would decline. The
upward pressure would continue until the expected return declined to match the
level of all other investments.
In fact, for different assets the expected returns per dollar invested differ markedly
from one another, because return is affected by a number of other important attributes.
These include risk, tax considerations, and liquidity (the ease with which an asset
can be sold).
RISK
Most of us do not like the risk that accompanies most future-oriented economic
activity. We might spend a few dollars on some lottery tickets or occasionally play
the slot machines, but for the most part we try to avoid or minimize risks. Economists
say that individuals are risk averse and their behavior displays risk aversion.
A prime consideration for any investor, therefore, is the riskiness of any investment
alternative. Bank accounts, in this regard, are safe. Since government deposit
insurance was instituted in the 1930s after the bank failures that occurred during the
Great Depression, no one in the United States has lost money in an insured bank
account. But investments in housing, stocks, and bonds and most other investments
involve risk. The return may turn out to be substantially lower, or higher, than
initially expected.
Historically, stocks have yielded a higher average return than bonds, but stocks
are riskier—prices on the stock market fluctuate, and they can do so quite dramatically.
On the single day of October 19, 1987, stock prices on the New York Stock
Exchange fell by 508 points, a drop in value of 23 percent.
Panel A of Figure 39.1 shows the closing monthly value of the Dow Jones industrial
average, an index of stock prices that is based on the prices of shares in major companies.
Today, thirty companies are included in the index, which was revised in 1999
to include such firms as Microsoft and Intel. Because the index has grown so much
since 1928, the 1929 stock market crash barely shows up in the figure. Though the
index fell in value almost 13 percent on October 28, 1929, this was a decline of only 38
points—well within the typical range of daily fluctuations in the market today. The
3 Based on an article by Jennifer Bjorhus, “PG&E’s ‘Family’ Falling Apart,” San Jose Mercury News, January
22, 2001, p. 1.
874 ∂ CHAPTER 39 A STUDENT’S GUIDE TO INVESTING