Copyright © 2006 Thomson Learning

2727The Basic Tools of Finance

Figure 1 Risk Aversion

Wealth0

Utility

Currentwealth €1,000

gain€1,000loss

Utility lossfrom losing€1,000

Utility gainfrom winning€1,000

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Figure 2 Diversification

Number ofStocks inPortfolio

49

(More risk)

(Less risk)

20

0 1 4 6 8 10 20 40

Risk (standarddeviation of

portfolio return)

Aggregaterisk

Idiosyncraticrisk

30

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Figure 3 The Trade-Off Between Risk and Return

Risk(standarddeviation)

0 5 10 15 20

8.3

3.1

Return(percentper year)

50%stocks

25%stocks

Nostocks

100%stocks

75%stocks

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