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

Review and Practice
SUMMARY
1. Investment options for individuals include putting savings
in a bank account of some kind or using them to buy
real estate, bonds, or shares of stock or mutual funds.
2. Returns on investment can be received in four ways: as
interest, dividends, rent, and capital gains.
3. Assets can differ in four ways: in their average returns,
their riskiness, their treatment under tax law, and their
liquidity.
4. By holding assets that are widely diversified, individuals
can avoid many of the risks associated with specific
assets, but not the risks associated with the market as
a whole.
5. Today’s price of an asset is influenced by expectations
of the asset’s price in the future. Expectation of a
higher price in the future will cause the asset’s price
to rise today.
6. Asset prices can be very volatile because expectations
about future returns can shift quickly.
7. The efficient market theory holds that all available information
is fully reflected in the price of an asset. Accordingly,
changes in price reflect only unanticipated events
and, therefore, are random and unpredictable.
8. There are four rules for intelligent investors: (1) evaluate
the characteristics of each asset and relate them to your
personal situation; (2) give your financial portfolio a
broad base; (3) look at all the risks you face, not just
those in your financial portfolio; and (4) think twice
before believing you can beat the market.
KEY TERMS
investment
real investment
financial investment
certificate of deposit (CD)
liquidity
dividends
retained earnings
capital gain
mutual fund
Treasury bills (T-bills)
diversification
expected returns
risk aversion
asset price bubbles
efficient market theory
random walk
portfolio
REVIEW QUESTIONS
1. Suppose an investor is considering two assets with
identical expected rates of return. What three characteristics
of the assets might help differentiate the
choice between them?
2. List the principal alternative forms of investment that
are available. What are the returns on each called?
Rate them in terms of the characteristics described in
Question 1.
3. True or false: “Two assets must have equal expected
returns.” If we modify the statement to read “Two assets
that are equally risky must have equal expected
returns,” is the statement true? Explain your answer.
4. If you found out that several company presidents were
buying or selling stock in their own companies, would
you want to copy their behavior? Why or why not?
5. What is the efficient market theory? What implications
does it have for whether you can beat the market? Does it
imply that all stocks must yield the same expected return?
6. Why do economists expect the market to be efficient?
7. What alternative interpretations are given to the observation
that individuals cannot, even by spending
considerable money on information, consistently beat
the market?
8. List and explain the four rules for intelligent investing.
9. True or false: “A single mutual fund may be a more
diversified investment than a portfolio of a dozen
stocks.” Explain.
REVIEW AND PRACTICE ∂ 887