Question

Q-3 Hakim Khaliq recently heard a conversation between a renowned fund manager and a high networth individual (HNI). The HNI wanted the fund manager to include 25-30 stocks in a portfolio that will maximize the returns and probably reduce the underlying risks. The fund manager responded that if he structures a portfolio that include those many stocks from different businesses, then possibly it will eliminate the risk but the portfolio returns would typically be equal to a t-bill or other similar risk-free assets’ returns. Critically evaluate the crux of the conversation in light with some theoretical aspects ?

Answer 1

Here when he recommends that he should add 25-30 stocks in the portfolio so that the underlying risk can be reduced so he is basically referring to the concept of diversification. The diversification is the idea that if you put large number of stocks in a portfolio which have negative correlation with each other then the overall risk of the portfolio will be reduced. The idea is to find a set of stock and reduce risk to a level which is acceptable not completely removing asset just because it has risk. The fund manager statement that the asset return would be equivalent to a risk-free rate is not completely true because the idea behind diversification is to reduce the risk to a level which is acceptable to the investor not getting rid of asset just because it has risk. Especially when the market is going through a volatile phase and the portfolio risk exposure has increased, adding negatively correlated asset at this time would actually help reduce the volatility in returns of the portfolio. For any financial asset if you want to generate high return you would have to take certain level of risk but through diversification, we can manage that level of risk.