Financial Market Theory Tuesday, September 5, 2017 Professor Edwin T Burton

Readings, So Far (Available on Collab) You should have already read Malkiel, “A Random Walk Down Wall Street” During the last two weeks, you should have read Chapters One, Two, Three and Four This week, you should read Chapters Five and Six September 5, 2017

Diversification What does it mean? We all understand “don’t put all of your eggs in one basket.” But, operationally, what does that mean? September 5, 2017

Historically There was little or no interest in diversification “Reminiscences of a Stock Operator” by Edwin LeFevre 1923 “Security Analysis” by Benjamin Graham and David Dodd Harry Markowitz changed all that (Ph.d from University of Chicago) 1955: “Portfolio Selection: Efficient Diversification of Investments” : defined “efficient portfolio” One of the implications of Markowitz’s work: Capital Asset Pricing Model Capital Asset Pricing Model (CAPM) Concludes that everyone should own the same “risk portfolio” Optimal way to take on risk is using leverage September 5, 2017

According to CAPM Adding assets that are “uncorrelated” to existing assets, improves “diversification” But, still no definition of “diversification” Examples where adding uncorrelated assets makes things worse when problems develop Not much economics in CAPM – all about statistics: correlations, covariances, standard deviations….nothing about interest rates, inflation, gdp or other economic measures September 5, 2017

Finite States Tomorrow has three possibilities: Good State Neutral State Down State