Question

In your initial response for this week, explain why a diversified portfolio can eliminate some, but not all, of the risk of the individual securities. Describe how the variance terms are effectively diversified away in a large portfolio, but the covariance terms are not. Given your assessment on the mechanics of a diversified portfolio, how would a portfolio with a large percentage (i.e., 25 – 40%) of Kimberly-Clark shares, need to be protected or adjusted in terms of accounting for portfolio risk? Or would it? Base your answers on your assumptions and documented portfolio theories, as noted in the textbook (Ross, et al., 2016). Additionally, would shares of Kimberly-Clark within a portfolio be considered a defensive stock? To answer this question, consider whether the company generates a significant amount of cash flow, and how much of it is used for dividends and share repurchases. How is Kimberly-Clark’s distribution policy impacting the company and is it increasing or decreasing its EPS and dividends-per-share?

Answer 1

Importance of diversification:

Diversification helps in reducing the risk and increasing the return on the securities. This is because when investments are made in many assets, there are chances that some assets will perform better and some will have poor performance and similarly it happens that some issuers will fulfill their obligation of paying their returns to investors while others don’t. in that case, the returns from a few assets will compensate for the loss of returns from other assets in which case, the investor is assured of increased returns.

The variance of the asset in case of a two asset is computed from 2*2 matrix. The variance is computed from an N*N matrix in the N asset case. If there are many assets, then the covariance terms are many when compared to the variance terms in the matrix. Hence it shows the fact that variance terms are effectively diversified whereas the covariance terms are not. Therefor a diversified portfolio can reduce only a few but not all risks associated with the securities.

Impact of Kimberley clark’s distribution impact the EPS & dividend per share:

Irrespective of the diversification of portfolio, there will always be some type of risk. The level of risk might determine the amount of return on investment. The most robust average returns in the long term are 10% followed by the corporate bonds that is 6%, treasury bonds that is 5.5% followed by treasury bills that is 3.5%. since higher returns come with greater risks, stocks are riskier compared to corporate bonds, corporate bonds are riskier compared to treasury bills and treasury bills than bank saving products.

A small portion of the portfolio is there which cannot avoid risk and they are called as systematic risk. Systematic and unsystematic risks are those securities that can effect either single or group of securities. Whereas covariance risks are those which can’t be diversified.

25-40% of percentage in the portfolio:

If the portfolio consists of more of shares, then the investor will be exposed to more risk than the amount he can tolerate. Rebalancing will enable the sale of high priced securities and reinvesting them in purchasing the low priced securities. This rebalancing will enable the investors to expand their investment in high growth sectors and expand the opportunity for growth in high potential sectors and keeping the portfolio in alignment with the risk return profile of the investors.

Defensive stock

A defensive stock generally provides a stable earnings irrespective of the situation of the overall stock market. Hence in this case, the Kimberley Clark shares within a portfolio can be considered as a defensive stock.