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By Wang X.-H., Wen Zh.-X.

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He concluded, as a result of statistical and mathematical reason- 34 Modern Portfolio Theory ing, that it was impossible to predict a given future movement in the price of a security since the probability was equal that the next move in that price would be either up or down. Subsequent studies corroborated Bachelier’s findings. For example, Paul Samuelson, who in 1970 became a recipient of the Nobel Prize in Economics and was one of the most influential economists of the twentieth century, became an early adherent to Bachelier’s observation.

25) Advisers should understand some other important work pioneered by Sharpe. He broke down the total risk in a portfolio into two different kinds of risk: uncompensated risk (also referred to as “unsystematic” risk or “nonmarket” risk) and compensated risk (also referred to as “systematic” risk or “market” risk). Uncompensated risk is the uncertainty of how news may affect the price of a particular company’s stock. For example, if a meat packing company is found to have unhealthy slaughtering conditions, the price of the company’s stock may fall even on a day when the overall stock market rises in price.

We can draw some conclusions from the above table. First, it’s quite clear that stocks have widely outperformed fixed-income investments. This reveals in a dramatic way the relationship between risk and return: an investor incurring more risk gets more return and one that incurs less risk gets less return. For example, if you had invested $1 in the large company stocks of the S&P 500 on January 1, 1926, it would be worth $2,286 (assuming reinvestment of dividends and no payment of taxes) at the end of 2003.

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