The Basic Tools of Finance

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The Basic Tools of Finance 27 The Basic Tools of Finance

Figure 1 Risk Aversion Utility Utility gain from winning €1,000 Utility loss from losing €1,000 €1,000 loss €1,000 gain Wealth Current wealth Copyright©2010 South-Western

Figure 2 Diversification Risk (standard deviation of portfolio return) (More risk) 49 Idiosyncratic risk 20 Aggregate risk (Less risk) 1 4 6 8 10 20 30 40 Number of Stocks in Portfolio Copyright©2010 South-Western

Figure 3 The Trade-Off Between Risk and Return (percent 100% stocks per year) 75% stocks 50% stocks 8.3 25% stocks No stocks 3.1 5 10 15 20 Risk (standard deviation) Copyright©2010 South-Western

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