Here’s why. A lion hunts for high returns and is willing to take on high risk.

So you might think she’d prefer A to T because it offers higher

returns. But recall that A consists of Southwest Airlines only. Holding one stock is a foolish way to pursue high returns because the lion bears specific
risk. Any serious setback to Southwest Airlines will torpedo her entire portfolio. (Risk-tolerant investors still dislike risk, just not as much as risk-
averse ones). So she should add other companies to diversify away this risk and move from A to T in Figure 7.14. If these additions reduce her risk
and return below her desired levels, she can then increase them by borrowing and moving up from T on the tangency line. It’s better to take on risk
by borrowing more rather than by bearing specific risk. (We’ll show formally in Chapter 8 that investors aren’t offered higher returns for bearing
specific risk because they can get rid of it by diversifying.) As a result, borrowing to invest more than her wealth in portfolio T offers a higher return
than A.
Similarly, a chicken might seek safety by running away from tech stocks and investing his entire portfolio in Coca-Cola, which has the lowest
standard deviation in Table 7.5. But that’s actually unsafe because he bears the specific risks of the utilities sector, such as a change in regulation. It’s
better for him to diversify away this specific risk by holding some more volatile stocks and moving to T. While this action alone could make his
portfolio too volatile, he has a solution: Take some of his money out of stocks and instead invest it in Treasury bills. It’s better to decrease risk by
buying Treasury bills rather than holding only utilities and bearing specific risk.
To reiterate, all investors should hold the same stock portfolio. Investors should differ in how much of that portfolio they hold. Chickens will only
put some of their money into the portfolio, and the rest into Treasury bills. Lions will borrow to invest more than their initial wealth into the portfolio.
But, to the extent that they hold stocks, they will hold the same stocks.

Market Risk
The lessons of our 10-stock portfolio apply to the market as a whole. If investors share the same information, all will hold the portfolio of stocks with
the highest Sharpe ratio—that is, the portfolio that is tangent to a lending-borrowing line. This outcome is summarized in Figure 7.16.

Page 208

◗ FIGURE 7.16
Lending and borrowing extend the range of investment possibilities. If you invest in the tangent portfolio T and lend or borrow at the risk-free interest
rate, rf, you can achieve any point along the straight line from rf through T. This gives you the highest expected return for any level of risk.

What does portfolio T look like? If all investors should hold the same stocks, and all stocks are held, this means that all investors should hold the
market portfolio. The market portfolio is the portfolio of all stocks in the economy, where the weights correspond to the fraction of the overall
market that each stock represents. For example, if Apple comprises 3% of the value of all traded stocks in the United States, then Apple will be 3% of
the market portfolio, and 3% of the stock portfolio held by both chickens and lions.
So we have another separation theorem. We separate the investor’s job into two stages. The first is to select the best portfolio of stocks, which is
the portfolio T with the highest Sharpe ratio. The second step is to blend this portfolio with borrowing or lending to match the investor’s willingness
to bear risk. Each investor holds just two investments—the market portfolio T and the amount of lending or borrowing. This result is known as the
two-fund separation theorem.
Because investors hold the entire stock market, all unsystematic risk is diversified away. All of the remaining systematic risk is market risk.
The straight line through T is thus known as the capital market line. It shows the trade-off between risk and return that an investor faces when he
decides how to allocate his savings between lending or borrowing and the market portfolio. The Sharpe ratio of the capital market line is:24

The equation for the line itself:

(7.4)

The subscripts M, which now replaces T, stands for “market” and p for the portfolios along the capital market line.

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Equation (7.4) means this: Suppose you’re more risk-averse than average. Rather than playing it safe and putting your entire savings in Treasury
bills, you’ve chosen to put part of your savings in the market, and as a result, your portfolio bears risk of σp. What return can you expect on your
portfolio for bearing this risk? Recall the Sharpe ratio is your extra return for each dollar invested, the extra return that you get for bearing risk. So, if
you’re bearing risk of σp, your extra return is σp times the Sharpe ratio. This extra return is over and above the risk-free rate that you’d get if you
played it totally safe. So, your overall expected return is given by Eq. (7.4).
The same logic applies to a risk-tolerant investor, although that investor may borrow to increase her stake in the market portfolio of stocks.

7.5 Self-Test
There are two stocks in the economy. One makes champagne, another shoelaces. Which of the two stocks will a risk-tolerant lion choose? Which
would a risk-averse chicken choose? Both can borrow and lend at the risk-free rate.

7-5 Should Companies Diversify?

We’ve seen how diversification reduces risk and thus makes sense for investors. You might think that this means that companies should diversify
since they’re supposed to act in shareholders’ interest. Perhaps an energy company should buy a media firm to reduce its exposure to climate change.
But the fact that diversification is good for investors does not mean that companies should pursue it. This is because investors can diversify
themselves. An investor who wants to reduce his climate change risk can take some of his money out of energy stocks and reallocate it to media. To
be sure, he’d have to pay brokerage costs, but this is much cheaper than if the energy company diversifies. As we’ll discuss in Chapter 32, if it buys a
media firm, it has to hire investment banks, pay a premium over the media company’s stock price, and spend time and money integrating the two
companies. Starting up a media operation would similarly be slow and expensive.
Because investors can diversify on their own account, they won’t pay any extra for a firm that is diversified. The whole is worth no more than the
sum of its parts. A conglomerate with both energy and media divisions is worth exactly the same as if those divisions were separate companies. If it
cost more, no investor would buy the conglomerate because he’d simply buy energy and media companies separately.
This is a crucial result because it implies value additivity. If the market values asset A (say, an energy business) at PV(A) and asset B (say, a
media business) at PV(B), value additivity means that the market value of a firm that holds only these two assets is

Why is this concept so important? Because it means that a manager can evaluate new investment opportunities in isolation. Let’s say the company
currently has business A and is considering whether to invest in a new project, B. She only needs to calculate the PV of project B Page 210
because that’s how much the value of her company increases if she takes the project. The whole is the sum of its parts. She doesn’t
need to take into account how project B meshes with her existing business A. It doesn’t matter whether it is negatively correlated and allows the
company to diversify away from its current operations, or positively correlated and would mean doubling down.
The idea of value additivity can be proved formally in several ways.26 Moreover, it can be extended for any number of assets. For example, a
three-asset firm combining assets A, B, and C would be worth PV(ABC) = PV(A) + PV(B) + PV(C), and so on. The bottom line is this: It doesn’t
matter how many existing businesses a company has, or what these businesses are. The value of a new project depends only on its own discounted
cash flows.

7.6 Self-Test

Izy’s Ice Cream (from Section 7-3) is worth $40 million and Ursula’s Umbrellas is worth $60 million. Their cash flows are perfectly negatively
correlated. They decide to merge. What will the value of the merged firm be?

KEY TAKEAWAYS
Historical-average rates of return depended on risk. Returns to investors have varied according to the risks the investors have borne. Safe
securities like U.S. Treasury bills have provided a long-term average return of only 3.7% a year. The stock market provided an average return of
11.5% and a risk premium of 7.8% over the safe rate of interest.
Risks can be measured by the standard deviation or variance of returns. The historical-average standard deviation of the U.S. stock market has
been just under 20%. Market standard deviations have been lower in recent decades, but spikes of high volatility have arrived unexpectedly—for
example, at the start of the COVID pandemic.
Specific vs. systematic risk. Most of the specific risk of individual stocks is eliminated in a well-diversified portfolio. The systematic risk that
remains depends on shared risks of the stocks in the portfolio. Shared risks are measured by the covariance between each pair of stocks. Covariance
depends on the standard deviations of the stocks’ returns (σi and σj) and the correlation coefficient between them (ρij).
Covariance of stocks i and j = σij = ρijσiσj
Portfolio risk. This is computed as a weighted sum of variances and covariances for all stocks in the portfolio. The general formula is:

Portfolio standard deviation σ is the square root of variance.

Efficient portfolios. Efficient portfolios offer the highest expected rate of return for each possible level of portfolio risk. Investors can combine
investment in efficient stock portfolios with lending or borrowing. By doing so they can identify one optimal stock portfolio from the set Page 211
of efficient portfolios. The optimal stock portfolio is the one with the highest Sharpe ratio:

The optimal portfolio is the market portfolio. Investors who share the same information will all buy the same portfolio of stocks, and adjust its
risk by also lending or borrowing depending on their personal risk tolerance. If all investors have the same information, they will all buy the market
portfolio of all traded common stocks. They can do so in practice by buying an index fund that tracks a broad market index.
The relevant risk of a stock is not its total risk, but systematic risk as only this risk cannot be diversified away. Since all investors hold the market
portfolio, systematic risk is market risk—it is the risk of a stock that is shared with the overall market.
Diversification makes sense for investors, not for corporations. Almost all serious investors diversify. This does not imply that firms should
diversify. Corporate diversification is redundant if investors can diversify cheaply and easily on their own. Since diversification does not affect the
value of the firm, present values add even when risk is explicitly considered. Thanks to value additivity, the net present value rule for capital
budgeting works even under uncertainty.
In this chapter, we have introduced you to a number of formulas. They are reproduced in the endpapers to the book. You should take a look and
check that you understand them.
Near the end of Chapter 9, we list some Excel functions that are useful for measuring the risk of stocks and portfolios.
FURTHER READING
For international evidence on market returns since 1900, see:
E. Dimson, P. R. Marsh, and M. Staunton, Triumph of the Optimists: 101 Years of Global Investment Returns (Princeton, NJ: Princeton
University Press, 2002). More recent data are available in the Credit Suisse Global Investment Returns Yearbook Summary, https://www.credit-
suisse.com/about-us/en/reports-research/studies-publications.html.
The Ibbotson Yearbook is a valuable record of the performance of U.S. securities since 1926 and is now published by Duff and Phelps:
R. Ibbotson, R. J. Grabowski, J. P. Harrington, and C. Nunes, Duff and Phelps 2020 Stocks, Bonds, Bills, and Inflation SBBI Yearbook,
https://www.duffandphelps.com/insights/publications/cost-of-capital/2020-sbbi-yearbook.
Useful books and reviews on the equity risk premium include:
P. Fernandez, E. de Apellaniz, and I. Fernández Acín, “Market Risk Premium and Risk-Free Rate Used for 81 Countries in 2020: A Survey,”
March 25, 2020. Available at SSRN: https://ssrn.com/abstract=3560869.
W. Goetzmann and R. Ibbotson, The Equity Risk Premium: Essays and Explorations (Oxford, U.K.: Oxford University Press, 2006).
R. Mehra (ed.), Handbook of the Equity Risk Premium (Amsterdam: North-Holland, 2007).
R. Mehra and E. C. Prescott, “The Equity Risk Premium in Retrospect,” in Handbook of the Economics of Finance, eds. G. M. Constantinides,
M. Harris, and R. M. Stulz (Amsterdam: North-Holland, 2003) Vol. 1, Part 2, pp. 889–938.

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PROBLEM SETS

Select problems are available in McGraw-Hill’s Connect. Please see the preface for more information.

1. Rate of return (S7.1) The level of the Syldavia market index is 21,000 at the start of the year and 25,500 at the end. The dividend yield on the
index is 4.2%.
a. What is the return on the index over the year?
b. If the interest rate is 6%, what is the risk premium over the year?
c. If the inflation rate is 8%, what is the real return on the index over the year?
2. Real versus nominal returns (S7.1) The Costaguana stock market provided a return of 95%. The inflation rate in Costaguana during the year was
80%. In Ruritania the stock market return was 12%, but the inflation rate was only 2%. Which country’s stock market provided the higher real rate
of return?
3. Arithmetic average and compound returns (S7.1) Integrated Potato Chips (IPC) does not pay a dividend. Its current stock price is $150 and
there is an equal probability that the return over the coming year will be –10%, +20%, or +50%.
a. What is the expected price at year-end?
b. If the probabilities of future returns remain unchanged and you could observe the returns of IPC over a large number of years, what would be
the (arithmetic) average return?
c. If you were to discount IPC’s expected price at year-end from part (a) by this number, would you underestimate, overestimate, or correctly
estimate the stock’s present value?
d. If you could observe the returns of IPC over a large number of years, what would be the compound (geometric average) rate of return?
e. If you were to discount IPC’s expected price at year-end from part (a) by this number, would you underestimate, overestimate, or correctly
estimate the stock’s present value?
4. Risk premium (S7.1) Here are inflation rates and U.S. stock market and Treasury bill returns between 1929 and 1933:

a. What was the real return on the stock market in each year?
b. What was the average real return?
c. What was the risk premium in each year?
d. What was the average risk premium?
5. Risk Premium (S7.1) Suppose that in year 2030, investors become much more willing than before to bear risk. As a result, they require a return of
8% to invest in common stocks rather than the 10% that they had required in the past. This shift in risk aversion causes a 15% change in the value
of the market portfolio.
a. Do stock prices rise by 15% or fall?
b. If you now use past returns to estimate the expected risk premium, will the inclusion of data for 2030 cause you to underestimate or
overestimate the return that investors required in the past?
c. Will the inclusion of data for 2030 cause you to underestimate or overestimate the return that investors require in the future? Page 213
6. Stocks vs. bonds (S7.1) Each of the following statements is dangerous or misleading. Explain why.
a. A long-term U.S. government bond is always absolutely safe.
 b. All investors should prefer stocks to bonds because stocks offer higher long-run rates of return.
c. The best practical forecast of future rates of return on the stock market is a 5- or 10-year average of historical returns.
7. Expected return and standard deviation (S7.2) A game of chance offers the following odds and payoffs. Each play of the game costs $100, so
the net profit per play is the payoff less $100.

Probability Payoff Net Profit

0.10 $500 $400

0.50 100 0

0.40 0 –100

What are the expected cash payoff and expected rate of return? Calculate the variance and standard deviation of this rate of return. (Do not make
the adjustment for degrees of freedom described in footnote 12.)
8. Average returns and standard deviation (S7.2) The following table shows the nominal returns on Brazilian stocks and the rate of inflation.
a. What was the standard deviation of the market returns? (Do not make the adjustment for degrees of freedom described in footnote 12.)
b. Calculate the average real return.

Year Nominal Return (%) Inflation (%)

2015 −41.4 10.7

2016 66.2 6.3

2017 26.9 2.9

2018 15.0 2.7

2019 32.6 3.7

2020 2.1 3.7

9. Average returns and standard deviation (S7.2) During the boom years of 2010–2014, ace mutual fund manager Diana Sauros produced the
following percentage rates of return. Rates of return on the market are given for comparison.
a. Calculate the average return and standard deviation of Ms. Sauros’s mutual fund.
b. Why do you need to know the interest rate to judge whether Ms. Sauros performed better or worse than the market?
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c. Would you be more likely to congratulate if the interest rate was high or low?
10. Risk and diversification (S7.3) Hippique s.a., which owns a stable of racehorses, has just invested in a mysterious black stallion with great form
but disputed bloodlines. Some experts in horseflesh predict the horse will win the coveted Prix de Bidet; others argue that it should be put out to
grass. Is this a risky investment for Hippique shareholders?
11. Diversification (S7.3) Here are the percentage returns on two stocks.
a. Calculate the monthly variance and standard deviation of each stock. Which stock is the riskier if held on its own?
b. Now calculate the variance and standard deviation of the returns on a portfolio that invests an equal amount each month in the two stocks.
c. Is the variance more or less than half way between the variance of the two individual stocks?

Month Digital Cheese Executive Fruit

January +15% +7%

February –3 +1

March +5 +4

April +7 +13

May –4 +2

June +3 +5

July –2 –3

August –8 –2

12. Risk and diversification (S7.3) In which of the following situations would you get the largest reduction in risk by spreading your investment
across two stocks?
a. The two shares are perfectly correlated.
b. There is no correlation.
c. There is modest negative correlation.
d. There is perfect negative correlation
13. Portfolio risk (S7.3–S7.4) True or false?
a. Investors prefer diversified companies because they are less risky.
b. If stocks were perfectly positively correlated, diversification would not reduce risk.
 c. Diversification over a large number of assets completely eliminates risk.
d. Diversification works only when assets are uncorrelated.
e. Diversification reduces systematic risk.
f. A stock with a low standard deviation always contributes less to portfolio risk than a stock with a higher standard deviation. Page 215
g. The contribution of a stock to the risk of a well-diversified portfolio depends on its market risk.

14. Portfolio risk (S7.4) To calculate the variance of a three-stock portfolio, you need to add nine boxes:
Use the same symbols that we used in this chapter; for example, x1 = proportion invested in stock 1 and σ12 = covariance between stocks 1 and 2.
Now complete the nine boxes.
15. Portfolio risk (S7.4)
a. How many variance terms and how many different covariance terms do you need to calculate the risk of a 100-share portfolio?
b. Suppose all stocks had a standard deviation of 30% and a correlation with each other of 0.4. What is the standard deviation of the returns on a
portfolio that has equal holdings in 50 stocks?
c. What is the standard deviation of a fully diversified portfolio of such stocks?
16. Portfolio risk (S7.4) Suppose that the standard deviation of returns from a typical share is about 0.4 (or 40%) a year. The correlation between the
returns of each pair of shares is about 0.3.
a. Calculate the variance and standard deviation of the returns on a portfolio that has equal investments in two shares, three shares, and so on, up
to 10 shares.
b. Use your estimates to draw a graph like Figure 7.12. How large is the underlying market variance that cannot be diversified away?
c. Now repeat the problem, assuming that the correlation between each pair of stocks is zero.
17. Portfolio risk (S7.4) Table 7.6 shows standard deviations and correlation coefficients for seven stocks from different countries. Calculate the
variance of a portfolio with equal investments in each stock.

⟩ TABLE 7.6 Standard deviations of returns and correlation coefficients for a sample of seven stocks

Note: Correlations and standard deviations were calculated using returns in each country’s own currency. In other words, they assume that the investor
is protected against exchange risk.

18. Portfolio risk (S7.4) Your eccentric Aunt Claudia has left you $50,000 in BP shares plus $50,000 cash. Unfortunately, her will requires Page 216
that the BP stock not be sold for one year and the $50,000 cash must be entirely invested in one of the stocks shown in Table 7.6. What
is the safest attainable portfolio under these restrictions?
19. Portfolio risk (S7.4) Hyacinth Macaw invests 60% of her funds in stock I and the balance in stock J. The standard deviation of returns on I is 10%,
and on J it is 20%. Calculate the variance and standard deviation of portfolio returns, assuming
a. The correlation between the returns is 1.0.
b. The correlation is 0.5.
c. The correlation is 0.
20. Efficient portfolios (S7.4) Figure 7.17 purports to show the range of attainable combinations of expected return and standard deviation.
a. Which diagram is incorrectly drawn and why?
b. Which is the efficient set of portfolios?
c. If rf is the rate of interest, mark with an X the optimal stock portfolio.

◗ FIGURE 7.17
See Problem 21
21. Efficient portfolios (S7.4)
a. Plot the following risky portfolios on a graph:

b. Five of these portfolios are efficient, and three are not. Which are inefficient ones?
c. Suppose you can also borrow and lend at an interest rate of 12%. Which of the portfolios has the highest Sharpe ratio?
d. Suppose you are prepared to tolerate a standard deviation of 25%. What is the maximum expected return that you can achieve if Page 217
you cannot borrow or lend?
e. What is your optimal strategy if you can borrow or lend at 12% and are prepared to tolerate a standard deviation of 25%? What is the
maximum expected return that you can achieve with this risk?
22. Portfolio risk and return (S7.4) Look back at the calculation for Southwest Airlines and Amazon in Section 7.4.
a. Recalculate the expected portfolio return and standard deviation for different values of x1 and x2, assuming the correlation coefficient ρ12 = 0.
Plot the range of possible combinations of expected return and standard deviation as in Figure 7.12.
b. Repeat the problem for ρ12 = +0.5.
23. Portfolio risk and return (S7.4) George Dupree proposes to invest in two shares, X and Y. He expects a return of 12% from X and 8% from Y.
The standard deviation of returns is 8% for X and 5% for Y. The correlation coefficient between the returns is 0.2.
a. Compute the expected return and standard deviation of the following portfolios:

Portfolio Percentage in X Percentage in Y

1 50 50

2 25 75

3 75 25

b. Sketch the set of portfolios composed of X and Y.

c. Suppose that Mr. Dupree can also borrow or lend at an interest rate of 5%. Show on your sketch how this alters his opportunities. Given that he
can borrow or lend, what proportions of the common stock portfolio should be invested in X and Y?
24. Portfolio risk and return (S7.4) Ebenezer Scrooge has invested 60% of his money in share A and the remainder in share B. He assesses their
prospects as follows:

A B

Expected return (%) 15 20

Standard deviation (%) 20 22

Correlation between returns 0.5

a. What are the expected return and standard deviation of returns on his portfolio?
b. How would your answer change if the correlation coefficient were 0 or –0.5?
c. Is Mr. Scrooge’s portfolio better or worse than one invested entirely in share A, or is it not possible to say?
25. Sharpe ratio (S7.4) Calculate the Sharpe ratios for portfolios A, B, and T in Table 7.5. Which portfolio offers the highest ratio?
26. Portfolio risk and return (S7.4) Here are returns and standard deviations for four investments. Page 218

Return (%) Standard Deviation (%)

Treasury bills 6 0

Stock P 10 14

Stock Q 14.5 28

Stock R 21 26

Calculate the standard deviations of the following portfolios.

a. 50% in Treasury bills, 50% in stock P.
b. 50% each in Q and R, assuming the shares have
Perfect positive correlation.
Perfect negative correlation.
No correlation.
c. Plot a figure like Figure 7.12 for Q and R, assuming a correlation coefficient of 0.5.
d. Stock Q has a lower return than R but a higher standard deviation. Does that mean that Q’s price is too high or that R’s price is too low?
27. Portfolio risk and return (S7.4) Percival Hygiene has $10 million invested in long-term corporate bonds. This bond portfolio’s expected annual
rate of return is 9%, and the annual standard deviation is 10%. Amanda Reckonwith, Percival’s financial adviser, recommends that Percival
consider investing in an index fund that closely tracks the Standard & Poor’s 500 Index. The index has an expected return of 14%, and its standard
deviation is 16%.
a. Suppose Percival puts all his money in a combination of the index fund and Treasury bills. Can he thereby improve his expected rate of return
without changing the risk of his portfolio? The Treasury bill yield is 6%.