Cases in finance

¶ … Finance

I would explain to Mary that when it comes to investing, risk is equivalent to volatility of returns. Therefore, riskier stocks are those whose returns vary the most compared to the market. This can be both good and bad for the investor, so a riskier stock offers the greatest potential upside, and the greatest potential downside.

I would explain that beta is the degree to which the stock moves in relation to the market. A beta over 1 means the stock is riskier than the market; under 1 means it is less risky. A stock's return should reflect its risk - a stock that returns better than the market is not necessarily a better stock to own, if its risk is higher than the market. All returns must be measured against their risk. Therefore, required return is what return is required to compensate for the risk that is undertaking in owning that stock.

Bill should demonstrate the meaning of diversification by using sample portfolios to illustrate the effects of diversification on risk reduction. From this demonstration, the advantages should be obvious, as the beta of the portfolio declines. A simple model like CAPM can be used to make the computations and illustrate the relationships.

4) This chart is based on a risk free rate of 3% and a market risk rate of 10%. A stock that is above the line would be undervalued, since its return is greater than what its beta would suggest; a firm that is under the line would be overvalued, since its return is lower than what its beta would suggest.

5) Interest rates affect the portfolio by affecting the risk free rate. If interest rates increase, so does the risk free rate; if they decrease, the risk free rate also decreases. This affects the expected return of the portfolio, although it does not affect the risk since it is the risk-free rate that interest rates impact.

6) Bill should not take Mary out of investing stocks altogether and switch to fixed income for a one key reason. Mary is in late middle age or early old age, so her investment time horizon is probably another thirty years. She may not need growth but it may be too early to move into a 100% income portfolio. Though she is not knowledgeable and is risk averse, it is the role of the adviser to improve her knowledge and comfort level if equities are more suitable for her at this time.

7) Bill should not indulge her wish to learn about cherry-picking undervalued stocks. The markets are assumed to have perfect information, so any presumption of truly picking undervalued stocks is risky, especially for an inexperienced investor like Mary. Moreover, she has more conservative investment needs than what would be offered by seeking such investments. Hot tips are not appropriate for an investor like Mary.

8) Exhibit 1 is missing 20%, which we will assume to be Boom, with expected rates of return extrapolated as +40% for high tech and -15% for counter-cyclical. Thus, the rate of return expected for the portfolio will be the weighted average of the expected returns for each segment. Therefore Expected Return for the Portfolio =

5) * [(.2)(-25)+(.2)(-20)+(.3)(15)+(.1)(25)+(.2)(40)] + (.5) * [(.2)(20)+(.2)(16)+(.3)(12)+(.1)(-9)+(.2)(-15)]

This gives us an expected return of 6.45%. If we extrapolate the index fund return in a Boom to be 20%, the expected return of the market is 5.9%. Therefore, the risk of the portfolio is equivalent to a beta of 1.09. This is reasonable, because counter-cyclical stocks will help to create a hedge in the portfolio against the wild swings in the high tech stocks.

9) if Mary put 70% into high tech and 30% into index fund, the portfolio's expected return would be 5.97%. This carries a lower risk than the previous example, and is lower than the risk she currently faces. This combination would be therefore better than either for her.