Finance studies how people allocate resources and manage risk over time. The time value of money means receiving money now is better than later, and present value calculations allow comparison of sums over different times. Risk-averse individuals can reduce risk through insurance, diversification among many unrelated risks to reduce idiosyncratic risk, and accepting lower returns. According to the efficient markets hypothesis, asset prices instantly reflect all available information so markets are efficient and random walks, but some question if irrational factors also affect prices.

1. 27 The Basic Tools of Finance

10. Figure 1 Risk Aversion Wealth 0 Utility Current wealth Copyright©2004 South-Western $1,000 gain $1,000 loss Utility loss from losing $1,000 Utility gain from winning $1,000

15. Figure 2 Diversification Number of Stocks in Portfolio (More risk) (Less risk) 0 1 4 6 8 10 20 40 Risk (standard deviation of portfolio return) 30 Copyright©2004 South-Western 49 20 Aggregate risk Idiosyncratic risk

17. Figure 3 The Tradeoff between Risk and Return Risk (standard deviation) 0 5 10 15 20 8.3 3.1 Return (percent per year) Copyright©2004 South-Western 50% stocks 25% stocks No stocks 100% stocks 75% stocks