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The Efficient Frontier article

ASSIGNMENTS- PART 1

The Security Market Line ties the expected return on stocks to the systematic no diversifiable risks.  The development of the model usually references studies indicating that investors holding as few as 15 stocks effectively reduce the risk of the portfolio down to the systematic level.  The compensation for the risk in investment is related to the risk associated with only the element of risk that cannot be diversified away

The Efficient Frontier article, “The 15-Stock Diversification Myth,” (see http://www.efficientfrontier.com/ef/900/15st.htm) discusses results of a recent study on stock variability and diversification.  The study by Burton Malkiel in a recent Journal of Finance is summarized in the article along with extended studies by William Bernstein, the author of efficient frontier.

After reading the article answer the following questions:

1. What did Malkiel’s study of individual stock volatility, correlation of stock returns and overall market volatility show?

SAMPLE ANSWER:

The Malkiel’s study of individual stock volatility shows how the myth of reducing non systematic risk by owning more stocks is false. The analysis shows that the only way to eliminate the whole non systematic risk and systematic risk by owning the whole market. This paper tries to reduce the myth by showing the individual stock volatility, correlation of stock returns and market volatility show.

2. What are the implications for diversification from these findings?

3. The article also looked at super stock performance and terminal wealth dispersion, as well as systematic standard deviation to measure standard deviation.  The measure of terminal wealth dispersion incorporates the impact of variation on the wealth of an investor after investing for a long number of years.  What was Bernstein’s main conclusion concerning the diversification and the number of securities that would be required to be held?  What are you thoughts on this issue?

USE EXCEL TO CALCULATE THE FOLLOWING QUESTIONS (4 to 7).

4. Universal Laser, Inc., just paid a dividend of $2.75 on its stock. The growth rate in dividends is expected to be a constant 6 percent per year, indefinitely. Investors require a 16 percent return on the stock for the first three years, a 14 percent return for the next three years, and then an 11 percent return thereafter. What is the current share price for the stock?

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