Question

Question: Briefly describe modern portfolio theory and relate it to the approaches supported by Walt and Shane. Be sure to mention diversifiable risk, undiversifiable risk, and total risk, along with the role of beta.

Walt Davies and Shane O’Brien are district managers for Lee, Inc. Over time, as they moved through the firm’s sales organization, they became close friends. Walt, who is 33 years old, currently lives in Princeton, New Jersey. Shane, who is 35, lives in Houston, Texas. Recently, they were discussing various company matters, as well as bringing each other up to date on their families, when the subject of investments came up. Each had always been fascinated by the stock market, and now that they had achieved some degree of financial success, they had begun actively investing.

As they discussed their investments, Walt said he thought the only way an individual who does not have hundreds of thousands of dollars can invest safely is to buy mutual funds. He emphasized that to be safe, a person needs to hold a broadly diversified portfolio and that only those with a lot of money and time can achieve independently the diversification that can be readily obtained by purchasing mutual fund shares.

Shane disagreed. He said, “Diversification! Who needs it?” He thought that what one must do is look carefully at stocks possessing desired risk-return characteristics and then invest all one’s money in the single best stock. Walt told him he was crazy. He said, “You’re just gambling.” Shane disagreed, explaining how his stockbroker had acquainted him with beta. Shane said that the higher the beta, the more risky the stock, and therefore the higher its return. By looking up the betas for potential stock investments on the Internet, he can pick stocks that have an acceptable risk level for him. Shane explained that with beta, one does not need to diversify; one merely needs to be willing to accept the risk reflected by beta.

The conversation continued, with Walt indicating that although he knew nothing about beta, he didn’t believe one could safely invest in one stock. Shane continued to argue that betas apply not just to a single stock but also to mutual funds. He said, “What’s the difference between a stock with a beta of, say, 1.2 and a mutual fund with a beta of 1.2? They have the same risk and should provide similar returns.”

As Walt and Shane discussed their differing opinions relative to investment strategy, they began to get angry. Neither was able to convince the other that he was right. Their voices now raised, they attracted the attention of the company’s vice president of finance, Elinor Green, who was nearby. She came over and said she had overheard their argument and thought that, given her expertise on financial matters, she might be able to resolve their disagreement. After hearing their views, Elinor responded, “I have some good news and some bad news for each of you. There is some validity to what each of you says, but there also are some errors in each of your explanations. Walt is right that diversification reduces risk. Shane is right that a mutual fund and a stock having the same beta should produce the same return.” Just then, the company president interrupted them, needing to talk to Elinor immediately. Elinor apologized for having to leave and offered to continue their discussion later that evening.

Answer 1

Modern Portfolio Theory (MPT) is an investing model where the investor attempts to take minimal level of market risk to capture maximum-level returns for a given portfolio of investments. MPT can help investors choose a set of investments that comprise one portfolio. Together, the investment securities combine in such a way as to reduce market risk through diversification while achieving optimal returns in the long run.

According to MPT, an investor can hold a particular asset type, mutual fund, or security that is high in risk individually but, when combined with several other asset types or investments, the whole portfolio can be balanced in such a way that its risk is lower than some of the underlying assets or investments.

Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries, and other categories. It aims to maximize returns by investing in different areas that would each react differently to the same event. As such Walt is correct of the opinion that to be safe, a person needs to hold a broadly diversified portfolio and that only those with a lot of money and time can achieve independently the diversification that can be readily obtained by purchasing mutual fund shares.

A risk quantifying statistic known as "beta (β)" comes from MPT. Beta is an attempt to quantify a portfolio's susceptibility to systematic risk within a market. A beta of 1 means the systematic risk exposure of a portfolio is the same as exists in the market. High beta means the stock price is more sensitive to news and information, and will move faster than a stock with low beta. In general, high beta means high risk, but also offers the possibility of high returns if the stock turns out to be a good investment. The beta of an investment security (i.e. a stock) is a measurement of its volatility of returns relative to the entire market. It is used as a measure of risk and is an integral part of the Capital Asset Pricing Model (CAPM). Therefore Shane was correct when he said that the higher the beta, the more risky the stock, and therefore the higher its return. Also he was correct when he said that betas apply not just to a single stock but also to mutual funds.

Total risk consists of two components: Systematic risk and unsystematic risk.

Systematic risk, also called non-diversifiable risk, is composed of risks that reflect broad economic activity, are market related, and affect all similar types of investments. The non diversifiable risk is the risk which cannot be diversified away.

Unsystematic risk, also called Diversifiable risk is the possibility that there will be a change in the price of a security because of the specific characteristics of that security. Diversification of an investor's portfolio can be used to offset and therefore eliminate this type of risk.The diversifiable risk is the risk that can be “washed out” by diversification and.

Examples of unsystematic risk include losses caused by labor problems, nationalization of assets, or weather conditions. This type of risk can be reduced by assembling a portfolio with significant diversification so that a single event affects only a limited number of the assets. Also called diversifiable risk.

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