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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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