Question

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 respond by saying how investing in 50 stocks instead of 10 stocks leads to risk reduction for the clients. Ringo should then explain the concept of idiosyncratic risks and systematic risks. Idiosyncratic risk (also known as unsystematic risk) is a specific risk that is associated with a particular industry or a company. Systematic risk, on the other hand, is the overall risk level that affects all assets, all industries and all sectors. Idiosyncratic risk can be diversified while systematic risk cannot be diversified.

Having exposure to 11 market sectors through 50 stocks enables me to ensure that our exposure to idiosyncratic risk is minimized. This is because of the fact that we have stocks in different industries that changes do not impact us much. For example we have exposure in the pharmaceutical industry as well as retail industry. So when the economy shrinks our stock holdings in the retail sector witness a decline in their value while the stocks in the pharmaceutical industry holds their ground and do not decline in value. This keeps our overall portfolio insulated.

When we pare the investment to only just 10 best ideas then we will not have exposure to all the 11 market sectors that we had in case of 50 stocks. This will increase our overall risk exposure and our portfolio will not be able to reduce its idiosyncratic risk to such an extent as was possible in case of 50 stocks. Thus with 50 stocks in the portfolio we are able to diversify better and hence minimize our idiosyncratic risk exposure.