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Example text
It turns out that these past betas for individual stocks are relatively poor predictors of future betas. While the problem is less severe for portfolios, which are averages of many stocks, it is clear that past betas are quite imperfect estimates of future volatility numbers. Moreover, as Roll (1977) has pointed out, it is impossible to observe the market's return against which we measure beta. In principle, the market includes all stocks, a variety of other financial instruments, and even nonmarketable assets.
5 percent return on his total investment. This simple illustration points out the basic advantage of diversification. 5 percent return each year. The trick that made the game work was that while both companies were risky (returns were variable from year to year), the companies were affected differently by weather conditions. As long as there is some lack of parallelism in the fortunes of the individual companies in the economy, diversification will always reduce risk. In the present case, where there is a perfect negative relationship between the companies' fortunes (one always does well when the other does poorly), diversification can totally eliminate risk.
4. The extraordinary net returns on equities around troughs average 24 percent, and no net return is less than 14 percent. In contrast, the extraordinary net returns on equities are negative around all peaks except that at the end of World War II. The average net return around peaks is -15 percent. 5 Annualized Difference between Returns on Equities and Bonds Near Troughs, Near Peaks, and in Other Periods (Percent) Near Near Troughs Peaks Other Months Excess Excess Near Troughs Near Peaks Jan 26-Feb 29 June 28-Nov 36 Oct 33-Aug 44 Jan 39-May 48 May 46-Jan 53 May 5~Feb 57 Dec 54-Oct 59 Nov 58-June 69 Sept 61-May 73 June 71-Dec 78 35 30 34 31 36 43 45 31 23 23 20 -4 -32 21 -9 -5 -11 -12 -13 -9 21 1 8 4 13 21 18 8 5 -4 14 29 26 27 23 22 27 23 18 27 -1 -5 -40 17 -22 -26 -29 -20 -18 -5 Mean Std.