User:Alexkachanov/Finance/Theory of Finance and Investment

Diversification
How much diversification does it take to remove all, or most, of the firm-specific risk in a portfolio? As noted above, 70% of households held five stocks or fewer. Is this enough to avoid the concentration problems? You actually need many more stocks in your portfolio to remove the firm-specific risk.

In order to earn a high return, you must take market risk. We want to take market risk while avoiding firm-specific risk. This is because we are compensated for market risk, but not for firm-specific risk. If you own just one stock, you are taking both types of risk. In fact, most of the risk you are taking is firm-specific risk. However, if you add one randomly selected firm to the firm you hold, you reduce the total risk in your portfolio by 24%. This risk reduction is completely due to the reduction in firm-specific risk. Add two more randomly selected stocks and the total risk in your portfolio is only 60% of the risk of holding just one stock.

Economists in the 1960s and 1970s examined this diversification issue and decreed that 10 to 12 randomly chosen stocks should adequately diversify away most of the firm-specific risk in a portfolio. However, this decision partially stemmed from the fact that buying and selling stocks was very expensive then. That is, commission costs were 10 times more than they are now. It now makes sense to reduce the firm-specific risk in your portfolio further by holding over 20 randomly selected stocks. In fact, a 30-stock portfolio is optimum.

Note from the figure that a completely diversified portfolio has about 39% of the risk of owning just one firm. Another way of interpreting this figure is that the risk of owning just one firm is 61% from firm-specific risk and 39% from market risk. The majority of the risk in a concentrated portfolio is the kind that offers no rewards.

Unfortunately, many investors are not getting this message.

Another important factor is that the firm-specific risk is reduced when randomly selected stocks are added to the portfolio. Investor portfolios are not typically created by randomly picking stocks. How does the non-random nature of stock picking affect diversification? The non-random stock picking can increase or decrease your risk reduction, depending on how it is done. For example, if you consciously pick stocks that are in different industries, you can fully diversify in less then 30 stocks. However, if you like to buy stocks that tend to be in one or two industries, you may not achieve good diversification with 100 stocks. Unfortunately, most investors concentrate their stock picks in one or two industries. The most common are technology and consumer companies, such as IBM, Microsoft, General Motors, General Electric, and Coca Cola.

Ссылки

 * фотографии реальных торговых площадок с пояснениями

People of Financial Science

 * Harry Markowitz


 * Franco Modigliani
 * Jack L. Treynor
 * Merton Miller
 * William Forsyth Sharpe


 * Fischer Black
 * Myron Scholes
 * Michael Jensen

Financial Science

 * The Quantitative Finance Timeline
 * Modern Portfolio Theory (MPT) was developed by Harry Markowitz and published under the title "Portfolio Selection" in the 1952 Journal of Finance.
 * The Capital asset pricing model (CAPM) was the work of financial economist (and, later, Nobel laureate in economics) William Sharpe, set out in his 1970 book "Portfolio Theory And Capital Markets".


 * Random walk
 * Коэффициент Beta

Efficient Market Hypothesis

 * Efficient Market Hypothesis


 * Louis Bachelier


 * Adam Smith
 * Léon Walras

Financial Instability Hypothesis

 * Financial Instability Hypothesis


 * Cauchy


 * Benoît Mandelbrot ->
 * Irving Fisher (1933) ->
 * John Maynard Keynes (1936) ->
 * Charles Kindleberger (1978) ->
 * Martin Wolfson (1986) ->
 * Hyman Minsky (1986)


 * Benoît Mandelbrot
 * 1) Fractals and Scaling in Finance by Benoit B. Mandelbrot


 * Keynes
 * 1) The Economic Consequences of the Peace (1919)
 * 2) The General Theory of Employment, Interest and Money


 * Hyman Minsky
 * 1) John Mayard Keynes (1975)
 * 2) Stabilizing an Ustable Economy (1986)

The problem of two-way causality between financial markets and economic fundamentals is a component of George Soros' theory of Reflexivity. Soros takes the argument further than is covered here, identifying still more factors contributing to Financial Market Instability. See "The Alchemy of Finance" by George Soros.

Прочее

 * Millennium Bridge - "The Wobbly Bridge"
 * Eurofighter jet


 * James Clerk Maxwell
 * 1) On governors (1868)


 * Control theory
 * Governor (device)

Текст
In one class of regulators of machinery, which we may call moderators[1],the resistance is increased by a quantity depending on the velocity. Thus in some pieces of clockwork the moderator consists of a conical pendulum revolving within a circular case. When the velocity increases, the ball of the pendulum presses against the inside of the case, and the friction checks the increase of velocity.

In Watt's governor for steam-engines the arms open outwards, and so contract the aperture of the steam-valve.

In a water-break invented by Professor J. Thomson, when the velocity is increased, water is centrifugally pumped up, and overflows with a great velocity, and the work is spent in lifting and communicating this velocity to the water.

In all these contrivances an increase of driving-power produces an increase of velocity, though a much smaller increase than would be produced without the moderator.

Synthetic CDO
Synthetic CDO's, in other words, are exemplars of a type of modern financial engineering known as derivatives. Essentially, derivatives are financial instruments that can be used to limit risk; their value is "derived" from underlying assets like mortgages, stocks, bonds or commodities. Stock futures, for example, are a common and relatively simple derivative.

The synthetic CDO grew out of a structure that an elite team of JPMorgan bankers invented in 1997. Their goal was to reduce the risk that Morgan would lose money when it made loans to top-tier corporate borrowers like IBM, General Electric and Procter & Gamble.

Regular CDOs contain hundreds or thousands of actual loans or bonds. Synthetics, on the other hand, replace those physical bonds with a computer-generated group of credit-default swaps. Synthetics could be slapped together faster, and they generated fatter fees than regular CDOs, making them especially attractive to Wall Street.

The bankers who invented the synthetics for JPMorgan say they kept only the highest-quality and most bulletproof portions of their product in-house, known as the super senior slice. They quickly sold anything riskier to firms that were willing to take on the dangers of ownership in exchange for fatter fees.

For years, the product that Masters and her colleagues invented remained just a mechanism for offloading risk in high-grade corporate lending. But as often occurs with Wall Street alchemy, a good idea started to be misused - and a product initially devised to insulate against risk soon morphed into a device that actually concentrated dangers.

This shift began in 2002, when low interest rates pushed investors to seek higher returns.

A few years ago, of course, some of the biggest returns were being harvested in the riskier reaches of the mortgage market. As CDOs and other forms of bundled mortgages were pooled nationwide, banks, investors and rating agencies all claimed that the risk of owning such packages was softened because of the broad diversity of loans in each pool.

In other words, a few lemons couldn't drag down the value of the whole package.

But the risk was beneath the surface. By 2005, with the home lending mania in full swing, the amount of CDOs holding opaque and risky mortgage assets far exceeded CDOs composed of blue-chip corporate loans. And inside even more abstract synthetic CDOs, the risk was harder to parse and much easier to overlook. The products allowed dicier assets to be passed off as higher-quality goods, giving banks and investors who traded them a false sense of security.