Page 91 - DCOM507_STOCK_MARKET_OPERATIONS

Stock Market Operations

Notes 4.8.1 Benefits of Diversification

The gains in risk reduction from portfolio diversification depend reciprocally upon the extent to
which the returns on securities in a portfolio are positively correlated. In an ideal manner, the
securities should exhibit negative correlation. This means that if a pair of securities has a negative
correlation of returns, then in circumstances where one of the securities is performing badly, the
other is likely to be doing well and vice versa in inverse circumstances. Thus, the average return
on holding the two securities is expected to be much ‘safer’ than investing in one of them alone.

Utility Function and Risk Taking

Common investors will have three possible attitudes to undertake risky course of action (i) an
aversion to risk (ii) a desire to take risk, and (iii) an indifference to risk.
The following example will clarify the risk attitude of the individual investors.

Example: The possible outcomes of two alternatives A and B are depicted in the table
below:

The Possible Outcomes of Two Alternatives A and B, Depending on the State of Economy

State of economy Possible outcome (`)
A B
Normal 100 100

Boom 110 200
Recession 90 –

If we presume that the three states of the economy are equally likely, then expected value for
each alternative is ` 100.
A risk-seeker is one who, given an option between more or less risky alternatives with
like expected values, prefers the riskier alternative that is, alternative B.
A risk averted would choose the less risky alternative that is, alternative A.
The person who is indifferent to risk (risk neutral) would be indifferent to both alternative
A and B, as they have same expected values.
The empirical facts show that mass of investors are risk-averse. Some generalisations concerning
the general shape of utility functions are probable. People normally regard money as a desirable
commodity, and the utility of a large sum is usually greater than the utility of a smaller sum.
Generally a utility function has a positive slope over a suitable range of money values, and the
slope probably does not vary in response to small changes in the stock of money. For little
changes in the amount of money going to an individual, the slope is constant and the utility
function is linear. If the utility function is linear, the decision-maker maximises anticipated
utility by maximising expected monetary value. Though, for large variations in the amount of
money, this is probable to be the case. For large losses and large gains, the utility function often
approaches upper and lower limits. The slope of the curve will usually increase sharply as the
amount of loss increases, as the disutility of a large loss is proportionately more than the
disutility of a small loss, but the curve will flatten as the loss becomes very large. For a risk-
averse decision-maker, the normal utility of a function is less than the utility of the anticipated
monetary value. It is also possible for the decision-maker to be risk favouring, at least over
some range of the utility function. In this case, the expected utility of a function is more than the
utility of the Expected Monetary Value (EMV).

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