Fin630 Vuabid

FIN 630

INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT Spring 2009 Assignment No. 3 ANS No 1:Mr. John is an investment analyst in the investment services area of IMS Financial Services Company and assigned to handle Mr. David’s account. As an investment advisor, Mr. John’s responsibilities are to make investment recommendations to his clients, execute trades on their behalf, and expand the demand for IMS financial services by making new contacts and clients. Mr. David’s account at IMS financial company is a portfolio of technology stocks worth $50,000." Just add a stock at random," advises Mr. Tom, another analyst in the same IMS office. "Pick a stock, any stock, and the risk of the portfolio should be lowered. Here, use my darts and throw them at the stock pages pasted on my office wall. The Markowitz model is typically thought of in terms of selecting portfolios of individual securities; indeed, that is how Markowitz expected his model to be used. As we know, however, it is a cumbersome model to employ because of the number of covariance estimates needed when dealing with a large number of individual securities. An alternative way to use the Markowitz model as a selection technique is to think in terms of asset classes, such as domestic stocks, foreign stocks of industrialized countries, the stocks of emerging markets, bonds, and so forth. Using, the model in this manner, investors decide what asset classes to own and what proportions of the asset classes to hold.

ANS No 2. Many knowledgeable market observers agree that the asset allocation decision is the most important decision made by an investor. According to some studies, for example, the asset allocation decision accounts for more than 90 percent of the variance in quarterly returns for a typical large pension fund. The rationale behind this approach is that different asset classes offer various potential

returns and various levels of risk, and the correlation coefficients between some of these asset classes may be quite tow, thereby providing beneficial diversification effects. As with the Markowitz analysis applied to individual securities, inputs remain a problem, because they must be estimated. However, this" will always ¥e a problem in investing, because we are selecting assets to be held over the uncertain future. 1. What percentage of portfolio funds is to be invested in each of the countries for which financial markets are available to-investors? 2. Within each country, what percentage of portfolio funds is to be invested in stocks, bonds, bills, and other assets? 3. Within each of the major asset .classes, what percentage of portfolio funds is to be invested in various individual securities?

ANS NO 3. The riskiness of the portfolio generally declines as more stocks are added, because we are eliminating the nonsystematic risk, or company-specific risk. This is unique risk related to a particular company. However, the extent of the risk reduction depends upon the degree of correlation among the stocks. As a general rule, correlations among stocks, at least domestic stocks and particularly large domestic stocks, are positive, although less than 1.0. Adding more stocks will reduce risk at first, but no matter how many partially correlated stocks we add to the portfolio, we can riot eliminate all of the risk. Variability in a security's total returns that is directly associated with overall movements in the general market or economy is called systematic risk, or market risk, or non diversifiable risk. Virtually all securities have some systematic risk, whether bonds or stocks, because systematic risk directly encompasses interest rate risk, market risk, and inflation risk. After the non systematic risk is eliminated, what is left is the non diversifiable portion, or the market risk (systematic part). This part of the risk is inescapable, because no matter how well an investor diversifies, the risk of the overall market cannot he avoided. Investors can construct a diversified portfolio and eliminate part of the total risk, the diversifiable or non market, part. As more securities are added, the non systematic risk

becomes smaller and smaller, and the total risk for the portfolio approaches its systematic risk. Since diversification cannot reduce systematic risk, total portfolio risk can be reduced no lower than the total risk of the market portfolio. Diversification can substantially reduce the unique risk of a portfolio. However, we cannot eliminate systematic risk. Clearly, market risk is critical to all investors. It plays a central role in asset-pricing, because it is the risk that investors can expect to be rewarded for taking.