Question: 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.

Walt Davies and Shane OBrien are district managers for Lee, Inc. Over time, as they moved through the firms sales organization, they became close friends. Walt, who is 33 years old, currently lives in Princeton, New Jersey. Shane, who is 35, lives in Houston, Texas. Recently, 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 funds. 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 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 ones money in the single best stock. Walt told him he was crazy. He said, Youre just gambling. Shane disagreed, explaining how his stockbroker had acquainted him with beta. 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.

The conversation continued, with Walt indicating that although he knew nothing about beta, he didnt believe one could safely invest in one stock. Shane continued to argue that betas apply not just to a single stock but also to mutual funds. He said, Whats 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 provide similar returns.

As Walt and Shane discussed their differing opinions relative to investment strategy, they began to get angry. Neither was able to convince the other that he was right. Their voices now raised, they attracted the attention of the companys vice president of finance, Elinor Green, who was nearby. She came over and said she had overheard their argument and thought that, given her expertise on financial matters, she might be able to resolve their disagreement. 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 is right that diversification reduces risk. Shane is right that a mutual fund and a stock having the same beta should produce the same return. 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.