Question

Respond to the following scenario: A prospective client comes into your office looking for investment advice. The client feels that she or he is appropriately diversified because the portfolio currently holds six different growth mutual funds, hence a large variety of equity securities.

a. Is this diversification?

b. How would you measure diversification between funds?

c. If this prospective client was 32 years old, and the funds in question were part of retirement savings, what would you advise the client regarding having an adequately diversified mutual fund portfolio?

Answer 1

(a): Yes, this can be considered or regarded as diversification. Diversification entails allocation of resources and investment money among different types of investments or asset class each having different risk profile. Here the client has invested in six different growth mutual funds and the risk profile of each fund would be different. Hence this will be diversification as it will enable the client to earn higher long term return with a lower level of risk exposure.

(b): To measure diversification between funds I will compute the percentage decrease achieved in the portfolio volatility as compared to the weighted average of the component volatilities. A risk reward framework will be developed.

(c ): My advice to the client would be to ensure that his retirement savings are allocated between different types of investments like equity, bonds, gold, real estate etc. The client is only 32 years old now and hence he can put majority of his investments in risky assets like equity. Once the client starts approaching the retirement age he should park his investments more in safe asset class like bonds and fixed income securities.