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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. 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.
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.
10) Bill should propose as a portfolio for Mary that includes a strong safety element. Her time horizon is around 20-30 years, so she should still retain some upside in the form of Index funds, and maybe a small component of high tech. However, her inexperience, conservative nature and inability to recuperate from losses means that safety is the highest priority. Therefore, I would propose a portfolio of 50% fixed income, 40% index funds, and 10% high tech. This has an expected return of 5.46%. In the worst case scenario, the portfolio loses 4% as the high tech and fixed income cancel each other out. In the best case scenario the portfolio gains a healthy 14.5%, so she still captures some of the market's growth potential.
Sources:
Mark McCracken, the Security Market Line [article online] 2006; Accessed August 19, 2008; available at http://www.teachmefinance.com/securitymarketline.html
Ben McClure, Modern…
Sources:
Mark McCracken, the Security Market Line [article online] 2006; Accessed August 19, 2008; available at http://www.teachmefinance.com/securitymarketline.html
Ben McClure, Modern Portfolio Theory: An Overview [article online] 2008; Accessed August 19, 2008; available at http://www.investopedia.com/terms/c/capm.asp
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