14. Treasury bills serve a purpose for investors who prefer a low-risk investment. The lower average rate of return compared to stocks is the price investors pay for predictability of investment performance and portfolio value.
15. With a top-down investing style, you focus on asset allocation or the broad composition of the entire portfolio, which is the major determinant of overall performance. Moreover, top-down management is the natural way to establish a portfolio with a level of risk consistent with your risk tolerance. The disadvantage of an exclusive emphasis on top-down issues is that you may forfeit the potential high returns that could result from identifying and concentrating in undervalued securities or sectors of the market.
With a bottom-up investing style, you try to benefit from identifying undervalued securities. The disadvantage is that investors might tend to overlook the overall composition of your portfolio, which may result in a non-diversified portfolio or a portfolio with a risk level inconsistent with the appropriate level of risk tolerance. In addition, this technique tends to require more active management, thus generating more transaction costs. Finally, the bottom-up analysis may be incorrect, in which case there will be a fruitlessly expended effort and money attempting to beat a simple buy-and-hold strategy.
16. You should be skeptical. If the author actually knows how to achieve such returns, one must question why the author would then be so ready to sell the secret to others. Financial markets are very competitive; one of the implications of this fact is that riches do not come easily. High expected returns require bearing some risk, and obvious bargains are few and far between. Odds are that the only one getting rich from the book is its author.
17. Financial assets provide for a means to acquire real assets as well as an expansion of these real assets. Financial assets provide a measure of liquidity to real assets and allow for investors to more effectively reduce risk through diversification.
18. Allowing traders to share in the profits increases the traders’ willingness to assume risk. Traders will share in the upside potential directly in the form of higher compensation but only in the downside indirectly in the form of potential job loss if performance is bad enough. This scenario creates a form of agency conflict known as moral hazard, in which the owners of the financial institution share in both the total profits and losses, while the traders will tend to share more of the gains than the losses.
19. Answers may vary, however, students should touch on the following: increased transparency, regulations to promote capital adequacy by increasing the frequency of gain or loss settlement, incentives to discourage excessive risk taking, and the promotion of more accurate and unbiased risk assessment.