Principles of Corporate Finance—Chap008.pptVIP

* * * * * * 3 2 2 2 2 2 Do you still remember we have a strategy to reduce the risk of any individual asset? The reason that diversification could reduce the risk of asset combination is because we have the correlation coefficient “Rou”. When different assets maintain the returns that are effected differently by the same factors, the change of return would not hurt the overall expected return of a portfolio in your hand. For example, when you have Dell stock which is a high growth industrial company and Intel stock, both are in top Fortune 500. Now, Intel, a micro chips industry firm, raises its price. Dell suffers from difficulties in selling its products due to the high production costs. The investors consider Dell stock may be negatively affected. However, as Intel maintains a lot of demanded companies, Thinkpad, HP, etc. Its increase in price may improve its earning. If you only hold Dell, stock you may lose. However, if you hold Intel and Dell, your total stock assets may not be affected. Why? Rou of Dell and Intel is negative. However, let’s consider that if at that time you only hold Intel. Your overall asset return will increase. Therefore, risk and return are trad-off. Harry MaMarkowitz is a professor of finance at the Rady School of Management at the University of California, San Diego (UCSD). He is best known for his pioneering work in modern portfolio theory, studying the effects of asset risk, return, correlation and diversification on probable investment portfolio returns.x Markowitz (born August 24, 1927) is an American economist, and a recipient of the 1989 John von Neumann Theory Prize and the 1990 Nobel Memorial Prize in Economic Sciences. According to Markowitz portfolio theory, the return of any asset in a long term should be normal distribution. Vertical axis is the frequency that the rate of return appeared from 1988-2008 of the rate of return (really gaining of price change). The horizontal axis is the daily return of stock (based on price). I