Walt Davies and Shane O’Brien are district managers for Lee, Inc. Over the years, as they moved through the firm’s sales organization, they became (and still remain) close friends. Walt, who is 33 years old, currently lives in Princeton, New Jersey. Shane, who is 35, lives in Houston, Texas. Recently, at the national sales meeting, 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 fund shares. 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 totally 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, “There is no way to measure risk conveniently—you’re just gambling.” Shane disagreed. He explained how his stockbroker had acquainted him with beta, which is a measure of risk. 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 and then hope for the best.
The conversation continued, with Walt indicating that although he knew nothing about beta, he didn’t believe one could safely invest in a single stock. Shane continued to argue that his broker had explained to him that betas can be calculated not just for a single stock but also for a portfolio of stocks, such as a mutual fund. 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 therefore provide similar returns.”
As Walt and Shane continued to discuss their differing opinions relative to investment strategy, they began to get angry with each other. Neither was able to convince the other that he was right. The level of their voices now raised, they attracted the attention of the company’s vice president of finance, Elinor Green, who was standing nearby. She came over and indicated she had overheard their argument about investments and thought that, given her expertise on financial matters, she might be able to resolve their disagreement. She asked them to explain the crux of their disagreement, and each reviewed his own viewpoint. 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 tends to support the traditional approach to portfolio management. Shane’s views are more supportive of modern portfolio theory.” 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.
Questions
a. Analyze Walt’s argument and explain why a mutual fund investment may be overdiversified. Also explain why one does not necessarily have to have hundreds of thousands of dollars to diversify adequately.
b. Analyze Shane’s argument and explain the major error in his logic relative to the use of beta as a substitute for diversification. Explain the key assumption underlying the use of beta as a risk measure.
c. Briefly describe the traditional approach to portfolio management and relate it to the approaches supported by Walt and Shane.
d. 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.
e. Explain how the traditional approach and modern portfolio theory can be blended into an approach to portfolio management that might prove useful to the individual investor. Relate this to reconciling Walt’s and Shane’s differing points of view. Case Problem 5.2 S
A. WALT'S ARGUMENT :
Mutual funds have to own so many stocks (due to the large amount
of cash they have) that it’s difficult to outperform their
benchmarks or indexes. Owning more stocks than necessary can take
away the impact of large stock gains and limit upside
Diversification protects from risk, but over-diversification may
lead to lower returns. Diversifying across categories gives an edge
when a category is underperforming. However, having many schemes in
the same category with similar stocks might hurt your capital when
the category is going through a bad phase it also makes portfolio
unmanageable. It is always good to choose only one scheme from one
category.
B. SHANE'S ARGUMENT:
The beta (β) of an investment security is a measurement of its volatility of returns relative to the entire market. It is used as a measure of SYSTEMATIC risk and is part of the Capital Asset Pricing Model (CAPM). A company with a higher beta has greater risk and also greater expected returns.
ASSUMPTIONS :
The beta coefficient theory assumes that stock returns are normally distributed from a statistical perspective .returns aren’t always normally distributed. Therefore, what a stock's beta might predict about a stock’s future movement isn’t always true.
A stock with a very low beta could have smaller price swings, yet it could still be in a long-term downtrend. It also evaluate it from other perspectives—such as fundamental or technical factors—before assuming it will add or remove risk from a portfolio.since beta is calculated using historical data points, it becomes less meaningful for investors looking to predict a stock's future movements.
Beta is also less useful for long-term investments since a stock's volatility can change significantly from year to year, depending upon the company's growth stage and other factors.
C TRADITIONAL APPROACH TO PORTFOLIO MANAGEMENT :
traditional portfolio ideology uses the individual’s income and capital goals and needs to formulate an investment strategy. a traditional approach analyzes a variety of factors in determining securities to invest in.
The traditional approach is carried out in the following
steps:
a) Analysis of constraints
b) Determination of objectives
c) Selection of portfolio
d) Assessment of risk and
return
e) Diversification - SHANE'S
DISTORTED UNDERSTANDING OF BETA HAS led him to believe that
diversifixation can be totally avoided if solely beta is used
D. MODERN PORTFOLIO THEORY FOR PORTFOLIO MANAGEMENT :
The goal in constructing a financial portfolio using the modern approach is to maximize returns on securities based on an agreed-upon level of risk. quantitative approach
theory on how risk-averse investors can construct portfolios to maximize expected return based on a given level of market risk.
Based on statistical measures such as variance and correlation, an individual investment's performance is less important than how it impacts the entire portfolio.
MPT assumes that investors are risk-averse, meaning they prefer a less risky portfolio to a riskier one for a given level of return. As a practical matter, risk aversion implies that most people should invest in multiple asset classes.
Diversifiable Risk, also known as unsystematic risk, is defined as the danger of an event that would affect an industry and not the market. This type of risk can only be mitigated through diversifying investments and maintaining a portfolio diversification
Systematic risk refers to the risk inherent to the entire market or market segment. Systematic risk, also known as “undiversifiable risk,” “volatility” or “market risk,” affects the overall market, not just a particular stock or industry. This type of risk is both unpredictable and impossible to completely avoid. It cannot be mitigated through diversification, only through hedging or by using the correct asset allocation strategy.
Total risk represents a combination of the systemic risk and unsystemic risk, including potential internal and external threats and liabilities, Identifying these risks requires performing a total risk assessment, which offers a comprehensive view of potential threats an organization might encounter.
A beta coefficient can measure the volatility of an individual stock compared to the systematic risk of the entire market.
E. COMBINING THE TWO APPROACHES FOR INDIVUAL INVESTORS :
The Traditional theory is primarily formed on common sense. It objectively judges individual options qualitatively using the usual analysis techniques. The MPT on the other hand is a much more mathematical, quantitative approach that focuses less on the individual option performance but more on how its selection impacts the portfolio on the whole. The concept of beta as a scale for volatility is flawed as it rests on the premise that the whole market return is normally distributed. Ultimately, an investor is using beta to try to gauge how much risk a stock is adding to a portfolio. While a stock that deviates very little from the market doesn’t add a lot of risk to a portfolio, it also doesn’t increase the potential for greater returns.
MPT and its more sophisticated formulas must be used to ascertain the impact an option has on the portfolio as a whole - using the TPT as a base for zeroing in on options
Walt primarily follows the TPT but is mistaken to believe that mutual funds are the only viable diversification options for those with lesser fund and that diversification is the only way out . Shane on the other hand holds a flawed notion of beta showing the risk in an option and is oblivious to the need of diversification. A stock with a very low beta could have smaller price swings, yet it could still be in a long-term downtrend. So, adding a down-trending stock with a low beta decreases risk in a portfolio only if the investor defines risk strictly in terms of volatility (rather than as the potential for losses). From a practical perspective, a low beta stock that's experiencing a downtrend isn’t likely to improve a portfolio’s performance.Similarly, a high beta stock that is volatile in a mostly upward direction will increase the risk of a portfolio, but it may add gains as well. It's recommended that investors using beta to evaluate a stock also evaluate it from other perspectives—such as fundamental or technical factors—before assuming it will add or remove risk from a portfolio.
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