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 s 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 investment he had invested his money into a few high growth companies. Over time his investment portfolio had growth 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 ...view middle of the document...
At their first meeting, Bill examined the Owen’s 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 is 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 don’t need to bear this much of risk.” Mary shrugged her shoulder 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 trade-off and on portfolio management. Accordingly, he scheduled another appointment for later that week and prepared the following exhibit to demonstrate the various nuances, expected return, and portfolio management (see Table 1).
|Expected Rate of Return |
| | | | | |High-Tech Company|Counter-Cyclical |
| | |Treasury Bills |Index Fund |Utility Company | |Company |
|Scenario |Probability | | | | | |
|Recession |20% | 4% |-2% |6% |-5% |20% |
|Near Recessions |20% |4% |5% |7% |2% |16% |
|Normal |30% |4% |10% |9% |15% |12% |
|Near Boom |10% |4% ...