A bit of wisdom attributed to the English poet Chaucer says, “nothing ventured, nothing gained.” Financial markets give us ample evidence that Chaucer knew what he was talk- ing about. Over time, high-risk investments tend to earn higher returns than do low-risk investments. When managers invest corporate funds, or when individuals decide how to allocate their money between different types of investments, they must weigh the trade-off between risk and return. The purpose of the next four chapters is to explore that trade-off in depth. We begin in Chapters 4 and 5 by describing two of the most common types of investments available in the market—bonds and stocks.
The bond market is vast, and it plays an extremely important role in the economy.
Federal, state, and local governments issue bonds to finance all kinds of public works projects and to cover budget deficits. Corporations sell bonds to raise funds to meet daily operating needs and to pay for major investments. Chapter 4 describes the basic bond features and explains how investors value bonds.
Chapter 5 examines the stock market. Valuing stocks is more complex than valuing bonds because stocks do not promise fixed payment streams as do bonds. Therefore,
Chapter 5 discusses methods that investors and analysts use to estimate stock values.
The chapter also provides a brief explanation of how firms work with investment bank- ers to sell stock to the public and how investors can trade shares of stock with each other. With the essential features of bonds and stocks in hand, Chapter 6 explores the historical returns earned by different classes of investments. The data illustrate that a fundamental trade-off between risk and return confronts investors. Chaucer was right.
Investors who want to get rich have to accept risk as part of the deal.
Chapter 7 quantifies exactly what we