Econ 13, Foldvary

Mankiw, Chapter 14

The basic tools of finance

Compounding: interest gets added to the principal and the next interest is therefore on a larger principal.

Present value: the market value today of a stream of income or an asset in the future.

Future value: F = P(1+i)**n

Present value: P = F/(1+i)**n

Application: lottery winnings

Rule of 69 (70 in bk):

i*t=69

Risk aversion: the preference for less risk.

Insurance spreads risk. People get insurance because dollars are worth more when we have few of them.

Investment risk is reduced by diversification.

Riskier assets have a higher return to make up for the chance of loss.

Stocks have a higher volatility risk than money market funds, but a higher long-run return.

Modern Portfolio theory shows how to get the highest returns relative to risk.

MPT is based on the proposition that financial markets tend to be rather efficient.

So MPT suggests index funds in several uncorrelated categories.

One selects a level of velocity risk, obtains categories for assets, buys index funds, and then periodically rebalances.

However, Marketocracy may have improved on MPT by selecting monthly porfolios that perform the best.