Question

Part 1: Discuss in general terms how age, income, debt level, assets, marital and parental status, risk tolerance, time horizon, and general economic conditions should be taken into consideration when constructing an investment portfolio. Why is it important to have a diversified portfolio?

Part 2: How does the Efficient Market Hypotheses fit in with a diversified portfolio? If the efficient market hypothesis is true, why is it still important to study stock fundamentals closely before purchasing any stock?

Answer 1

Part1 :

Age: Age is a very important factor while constructing an investment portfolio. The less is the age more an investor can take the risk as one has more years to earn and invest and hence risk-taking ability will be more the. The more is age portfolio should have a very less risky asset.

Income: If the income is fixed every month and there is a guarantee of income then the risk-taking ability will be high and when the income is uneven and not guaranteed then the risk-taking ability is reduced.

Assets and Debt level: If an investor has less debt level then he may invest in a more risky asset as the fixed interest service of debt will be less.

Marital and Parental Status: If an investor is not married then he can save more money and can invest in the risky asset and generate more income if he is married then saved income will be less and the risk-taking ability will be less

Risk Tolerance: Risk tolerance varies from investor to investor if the investor has high-risk tolerance then the exposure to the equity can be more if one has less risk tolerance then the debt investment in the portfolio will be high.

Time Horizon: If the time horizon of investment is high then the investor can tolerate the short term volatility hence the exposure in equity can be more and if the time horizon of investment is less then the debt is a favorable option.

General Economic Condition: If the economy is in recession then one may have a less risky asset in a portfolio like debt or gold. If the economy is in boom then one may take exposure in equity.

It is very important to have a diversified portfolio to remove the unsystematic risk. Diversified portfolio generates more profit with less risk hence risk-reward ratio improves.