financial advisors warn that interest rates on Treasury and corporate bonds are near record lows. If these
rates rise to their historical average, bondholders will incur significant losses.
4.1 How to Build an Investment Portfolio (pages 88–95)
Learning Objective: Discuss the most important factors in building an investment portfolio.
A. The Determinants of Portfolio Choice
The determinants of portfolio choice include wealth, an asset’s expected rate of return
compared with the expected returns on other assets, an asset’s degree of risk compared with the
risk from investing in other assets, an asset’s liquidity compared with the liquidity of other
assets, and the cost of acquiring information about the asset relative to the cost of acquiring
information about other assets.
An increase in wealth tends to increase the demand for most financial assets. Demand for some
assets, such as CDs, stocks, and bonds, are likely to increase more, while other assets, such as
checking accounts, increase less. People choose to acquire assets with higher expected rates of
return. Investors need to consider possible returns and the probability of those returns occurring
when estimating expected returns. Risk is the degree of uncertainty in the return of an asset.
Most investors are risk averse and will choose to invest in a risky asset only if they are
compensated by receiving a higher return. As a result, we tend to view a trade-off between risk
and return. The greater an asset’s liquidity, the more desirable the asset is to investors. So, an
investor will be willing to receive a lower return on a liquid asset compared to an asset that is
less liquid. Investors find assets more desirable if they do not have to spend time or money
acquiring information about them. All else equal, investors will accept a lower return on an
asset that has lower costs of acquiring information.
B. Diversification
To reduce risk, investors typically multiple assets, such as shares of stock issued by different
companies. Diversification can eliminate idiosyncratic risk, the risk associated with a particular
asset. Much of the remaining risk is market risk or systematic risk, risk that is common to all
assets of a certain type. Diversification cannot eliminate systematic risk.
Teaching Tips
In Making the Connection: Fear the Black Swan! on pages 91–92, the authors introduce the concept of a
“black swan event” that was developed by Nassim Taleb, professional investor and professor at New York
University. The basic idea of a black swan is that, occasionally, there are “unique” events that take place
(more often than people think) that have a significantly adverse effect on returns. In an article titled
“Preparing for the Next Black Swan” in the Wall Street Journal (August 21, 2010), Taleb points out that
diversification may not be sufficient in reducing risk when there are black swan events. For example, during
the financial crisis in late 2008, virtually all asset classes declined in value at the same time. Instead of
relying only on diversification, investors may instead want to use various forms of derivatives to prepare
for black swans. However, there is no free lunch, because there are costs involved in purchasing
derivatives while they may rarely be used. The authors explore this topic further in Chapter 7,
“Derivatives and Derivative Markets.”
4.2 Market Interest Rates and the Demand and Supply for Bonds (pages 95–105)
Learning Objective: Use a demand and supply model to determine market interest rates for bonds.
A. A Demand and Supply Graph of the Bond Market