Page 536 - Introduction to Business

510 PART 5 Finance

percentage ownership of stocks will be higher than the targeted amount of 50
percent. Sell off some stocks and buy bonds and money market securities until
you get back to your target mix of securities.
You might have noticed that rebalancing sells securities that have increased in
value more than others and buys securities that have increased in value less than
others. In this way, investors can benefit from selling high and buying low. By
spreading savings across a wide variety of securities and different investment com-
panies, investors can achieve a reasonable degree of portfolio diversification.
Portfolio diversification is beneficial in that it tends to decrease the risk or volatility
of earnings from investments. Given that most investors are risk averse, portfolio
diversification is a rational response to the fact that stocks and bonds can be risky
investments. Some pension funds, such as Enron’s private pension plan, invested
all of employees’ savings in only Enron stock. When the company failed, many
employees lost all of their savings. Clearly, this investment strategy was severely
flawed because it did not take advantage of the risk-reducing benefits of portfolio
diversification.

Institutional Investors. Today, insurance companies, pension funds, and
investment companies are major institutional investors that can have powerful
effects on financial markets around the world. If these institutional investors decide
that a firm is risky and sell its bonds and stocks, the firm will immediately suffer
from lower bond and stock prices, which translate into higher costs of debt and
equity funds. Institutional investors can affect even countries, as they move funds
from one country to the other in search of higher returns per unit risk. Large out-
flows of investment funds from a country can result in slower business sector
growth, lower employment and wages, and a lower standard of living.
Some experts believe that these large investors have increased market volatility.
Herd behavior can occur at times. For example, when many institutions began sell-
ing stocks at the same time on October 19, 1987, the stock market fell 24 percent in
one day. Known as Black Monday, billions of dollars of wealth were wiped out in a
matter of hours. Rapid movements of prices have caused stock exchanges to imple-
circuit breakers Temporarily stopping ment circuit breakers that act like speed bumps, stopping or slowing down trading
or slowing down the trading of stocks when security prices fall too rapidly for buy orders to keep up with sell orders of
and bonds by a securities exchange
securities from institutional traders.

Managing a Financial Institution
Financial institutions manage a two-stage production process (see Exhibit 14.1). In
stage one, deposits and savings of the public are obtained by issuing indirect secu-
rities of various kinds, such as deposit accounts, insurance policies, pension plans,
and unit shares of ownership. In stage two, the funds acquired in stage one are
loaned or invested. The difference between total revenues on loans and invest-
ments and total costs of funds is net income before taxes. If we divide net income
after taxes by total assets, we get the return on assets (ROA). This financial ratio is a
good indicator of how well managers utilized the institution’s assets to generate
profits. A typical ROA among financial institutions is about 1 percent. By dividing
net income after taxes by total equity, we get the return on equity (ROE). This profit
measure is closely watched by the institution’s common shareholders. While finan-
cial institutions seek to maximize both of these profit measures, ROE is relatively
more important than ROA, as shareholders ultimately control privately-owned
institutions.

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