"Case 17 Flirting with Risk

Risk and Return

Flirting with Risk

When Mary Owens' husband, Ralph, passed away about three months ago he

left behind a small fortune, which he had accumulated by living a very

thrifty life and by investing in common stocks. Ralph had worked as an

engineer for a surgical instruments manufacturer for over 30 years and

had taken full advantage of the company's voluntary retirement savings

plan. However, instead of buying a diversified set of investments he had

invested his money into a few high growth companies. Over time his

investment portfolio had grown to about $900,000 being primarily

comprised of the stocks of 3 companies. He was very fortunate that his

selections turned out to be good ones and after numerous stock-splits

the prices of the three companies had appreciated significantly over

time.

Mary, on the other hand, was a very conservative and cautious person.

She hild devoted her life to being a stay-home mom and had raised their

two kids into finc adults, each of whom had a fairly successful career.

Jim, 28, had followed in Ralph's footsteps. In addition to being

gainfully employed as an engineer, he was pursuing an MBA at a

prestigious business school. Annette, 26, was completing her residency

at a major metropolitan hospital. Although Mary and Ralph had enjoyed a

wonderful married life, it was Ralph who managed almost all the

financial affairs of their family. Mary, like many spouses of their

generation, preferred to focus on other family matters.

It was only after Ralph's passing on that Mary realized how unprepared

she was for the complex decisions that have to be made when managing

one's wealth. Upon the advice of her close friend, Agnes, Mary decided

to call the broker's office and request that her account be turned over

to Bill May, the firm's senior financial advisor. Agnes, a widow

herself, had been very happy with Bill's advice and professionalism. He

had helped her rebalance and re-allocate her portfolio with the result

that her portfolio's value had steadily increased over the years without

much volatility.

At their first meeting, Bill examined the Owens' portfolio and was

shocked at how narrowly focused its composition had been. In fact, just

during the past year --due to the significant drop in the technology

sector --the portfolio had lost almost 30% of its value. "Ralph,

certainly liked to flirt with risk," said Bill. "The first thing we are

going to have to do is diversify your portfolio and lower its beta. As

it stands you could make a lot of money if the technology sector takes

off, but the reverse scenario could be devastating. I am sure you will

agree with me that given your status in life you do not need to bear

this much of risk." Mary shrugged her shoulders and looked blankly at

Bill. "Diversify.. .Beta...

what are you talking about? These terms are new to me and so confusing.

You are right, Bill, I don't need the high risk but can you explain to

me how the risk level of my portfolio can be lowered?" Bill realized

right away that Mary needed a primer on the risk-return tradeoff and on

portfolio management. Accordingly, he scheduled another appointment for

later that week and prepared the following exhibit to demonstrate the

various nuances of risk, expected return, and portfolio management.

Exhibit 1

Expected Rate of Return (%)

Scenario Probability Treasury Index Utility High-Tech Counter-cyclical

Recession 20% 5% -10% 6% -25% 20%

Near Recession 20% 5% -6% 7% -20% 16%

Normal 30% 5% 12% 9% 15% 12%

Near Boom 10% 5% 15% 11% 25% -9%

Boom 20% 5% 20% 14% 35% -20%

4. Using a suitable diagram explain how Bill could use the security

market line to show Mary which stocks could be undervalued and which may

be overvalued?"

5. During the presentation. Mary asks Bill Lets say I choose a well diversified portfolio, what effect will interest rates have on my portfolio?How should Bill respond?

6. Should Bill take Mary out of investing in stocks and preferably put all her money in fixed-income securities? Explain.

7. Mary tells Bill, I keep hearing stories about how people have made thousands of dollars by following their brokers hot tips.Can you give me some hot tips regarding undervalued stocks?How should Bill respond?

8. If Mary decided to invest her money equally in high-tech and counter-cyclical stocks. What would her portfolios expected return and risk level be?Are these expectations realistic?Please explain.

9. What would happen if Mary were to put 70% of her portfolio in the High-Tech stock and 30% in the Index Fund?Would this combination be better for her? Explain.

10. Based on these calculations what do you think bill should propose as a possible portfolio combination for mary?