Question

1) Ringo Fonebone, CFA invests his clients’ money in a 50-stock portfolio comprised of his best ideas across the 11 market sectors. Following a recent meeting, the client stated the following:

“Ringo, I trust your stock-picking ability and believe you should invest my money in your 10 best stock ideas instead of 50. Why dilute your ideas across 50 companies instead of your top 10 BEST ideas which relfect your strongest views? Furthermore, stocks are risky so as you add more stocks to the portfolio – especially those where you are less confident in their prospects. Wouldn’t you be INCREASING the portfolio's risk?  

Critically evaluate the client’s statement and how suggest how Ringo should respond. Include in your discussion, the concept of systematic & idiosyncratic risks and how these risks change with the number of stocks in a portfolio. (20 pts)

Answer 1

Ringo should responds as below;

By taking 50 stock into account we are reducing the portfolio risk especially Idiosyncratic risk ( Diversifyable risk). Here we have taken 50 stocks from 11 different industries which means if an industry is significantly gets affected( like auto industry during covid), due to the presence of stocks in other industries, our net return will be fairly have less deviation which means lesser risk.

Hence to reduce portfolios risk its better to take all 50 stocks. If we select 10 top performing stock, diversification wont be happening.

Also selecting more stocks reduces the systematic risk because of different beta levels for the stocks which make a portfolio beta closer to market index value or less than that. Generally higher beta implies higher risks, but for better returns, we need higher beta stocks but to reduce the risk we can include some stocks with lower beta and neutralize the risk.

Hence overall selecting 50 stocks instead of 10 will be better.