Structure Of The Investment Process

Published Date: 02 Nov 2017

FACULTY OF BUSINESS AND FINANCE

ACADEMIC YEAR 2013/2014

BACHELOR OF FINANCE (HONS)

YEAR 2

Assignment Mark Sheet

Question

Marks Awarded

Case Study 1

/20

Case Study 2

/20

Case Study 3

/20

Case Study 4

/10

Case Study 5

/30

TOTAL

100

Examiner’s Name : ____Puan.Nurul Nabila Binti Jasli

Examiner’s Signature : ________________________

No

Student ID

Name

(1)

　12ABB00213

　Goh Huei Wen

(2)

　11ABB04812

　Hon Siew Yan

(3)

　10ABB00528

　Ng Siang Aw

(4)

12ABB01008

Toh Kim Mei

(5)

10ABB05982

Wong Jing Wen

Case Study 1 (20 marks)

Chan and Dodi, have been good friends since high school. Each has already found a job that will begin after graduation. Chan has accepted a position as an internal auditor in a medium-size manufacturing firm. Dodi will be working for one of the major public accounting firms. Each is looking forward to the challenge of a new career and to the prospect of achieving success both professionally and financially.

Currently they are having two elective of new course registration. Chan is considering taking a golf course which may help him socialize in business career. Dodi in contrast wish to take a basic investment course and been trying to convince Chan to take investment course rather than golf course. Chan believes he doesn’t need to take investment course because he already knows what common stock is. He believes that whenever he has accumulated excess funds, he can invest in the stock of a company that is doing well. Dodi argues that there is much more to it than simply choosing common stock. He feels that exposure to the field of investments would be more beneficial than learning how to play golf.

(a) Explain to Chan the structure of the investment process and the economic importance of investing. (6 marks)

The investment process is an established method which the fund managers make decisions what to buy and what to sell. The investment process involved in three steps which is understand the clients, portfolio construction, and evaluate portfolio performance.

Step 1: Understand the clients

In the investment process, the investor acts as client and portfolio manager will starts to perceive what the investors needs ,the client’s tax status, and preference. Portfolio manager is a person who makes investment decisions by using money other people have placed under his or her control or a person who manages a financial institution's asset and liability portfolios. The understanding of investors' own needs and preferences is a very important step to be taken in this stage for portfolio manager. The misunderstanding of needs and preferences will causes the portfolio manager take the wrong decision and choose wrong portfolio.

Step 2: Portfolio Construction

The portfolio construction is the investment in a range of funds that work together in order to create an investment solution for investors. The portfolio construction process is designed to ensure that the allocations to investment strategies and managers are consistent with the portfolio’s risk and return objectives.

The actual construction of the portfolio can distribute into three sub-parts. The first one is the portfolio allocation across varies asset classes. Portfolio allocation encompasses the classes of assets included in a portfolio and the proportion of investment dollars assigned to each asset class. The asset classes include equities, fixed income bonds, commodities, real estate and alternative investments. portfolio allocation involves the determination of percentage of a portfolio allocated to each asset class. An investor with a low risk tolerance should follow a strategy that places a greater emphasis on income and capital preservation. An investor with a higher risk tolerance should follow a strategy focused more on increasing wealth. An allocation strategy seeks to use the characteristics of each asset class to help an investor reach his goal. Hence, investors should allocate their portfolios to a combination of asset classes. The diversification of the portfolio will reduce the risk. The second component is the asset selection decision. The asset allocation involves picking individual assets within each asset class to make up the portfolio. Investors choose the asset classes based on the risk tolerance and financial goals. A general rule of thumb is that the lower your risk tolerance, the greater the percentage of your portfolio that should be allocated to fixed income. The final component is execution. The investors put the portfolio together and trade off transactions cost against transaction speed.

Step 3: Evaluate Portfolio performance

The portfolio performance evaluation primarily refers to the determination of how a particular investment portfolio has performed relative to some comparison benchmark. The purpose of evaluation of the portfolio performance is to indicate whether the portfolio has outperformed or under-performed, or whether it has performed at par with the benchmark and the investors able to know the relative performance of the portfolio and the investors can forecast the approaches investing in the future.

The economic importance of investing:

The performing of investments, viewed in terms of volume, leads to the economic increase, by increasing the goods and services, and through the quality of the performed investments we obtain the increase of the consumers’ life quality. The role of investments in the economic recovery derives also from the fact that they are a factor for the stimulation and increase of demand and tender on the market.

Firstly we talk about the development of the production of goods and services that appear on the market, bring diversity of assortments, hence the increase of the demand brings with it the development of the economic entity, as well as the creation of new work places. Thus, the investments are very important in the development of the human community as well. Strictly viewed in economic terms, the investments lead to the economic recovery and increase through the cyclic character of incomes obtained from the investment performance. Thus, the implementation of a new investment, attracts incomes for the implementing entity but also for other economic entities, because the performance of an investment means the launching of the demand and tender in that field, the demand from the entity that performs the investment, and the tender from the connected entities that can offer the goods and services necessary for the investment performance. The investment performance attracts incomes for the entity that implements it, but also incomes for the entities that participate to the investment by offering goods and services. The incomes obtained in both cases go back to economy, attracting other investments and the creation of new incomes.

(b) List and discuss the other types of investment vehicles with which Chan is apparently unfamiliar. (6 marks)

Some of the other types of investment vehicles with which Chan is apparently unfamiliar are bonds, mutual funds, traditional IRA, index funds and stock investments.

In finance, a bond is an instrument of indebtedness of the bond issuer to the holders. It is a debt security, under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest (the coupon) and/or to repay the principal at a later date, termed the maturity. Bonds is grouped under the general category called fixed-income securities. Normally, investors would invest in the government bonds or corporate debt obligations. The revenue of bonds is typically fixed. When you purchase a bond, they will paid back you the amount of the money you invest comes with the interest on money. Bond is extremely safe compare to other investment vehicle. Investment in bond indicate very low risk, however low return too. The rate of return on bonds is generally lower than other securities.

Mutual Fund is a collection of stocks and bonds. It is a type of professionally managed collective investment vehicle that pools money from many investors to purchase securities. When you buy a mutual fund, you are pooling your money with a number of other investors, which enables you as part of a group to pay a professional manager to select specific securities for you. Mutual funds are generally classified by their principal investments. The four main categories of funds are money market funds, bond or fixed income funds, stock or equity funds and hybrid funds The advantages of a mutual fund is the ability to participate in investments that may be available only to larger investors. Mutual funds typically invest in different types of securities including money market, bonds, and stock securities. The risk levels with this type of investment vary depending on the mutual fund holdings.

Traditional IRA   is an individual retirement account (IRA) in the United States. The IRA is held at a custodian institution such as a bank or brokerage, and may be invested in anything that the custodian allows. It is savings plan for the individual that offers tax advantages for retirement savings. The Roth IRA is a savings plan for the individual where the earnings are not taxed. The contribution of traditional IRA is often tax-deductable. Another advantage of a Traditional IRA is that the taxpayer gets the tax benefit immediately.

Index funds invest in specific market indexes. An index fund or index tracker is a collective investment scheme that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant. The advantages of index funds are index funds is low costs and lower turnovers. They are designed to mirror the performance of a designated bond or stock. The risk level for this type of investment depends on the index that the fund utilizes.

Stock investments represent a share in the piece of a company. As the stock prices rise or fall, so does the value of the investment. This type of investment is considered a medium to high risk.

(c) Assuming that Chan already get plenty of exercise, what arguments would you give to convince Chan to take investment course rather than golf course? (8 marks)

Taking investment course is better than taking golf course in a fact that when you learnt to invest, you can gain access to extra income by investing despite from the fixed income of the job salary and investment will not be merely gamble of luck but out of careful considerations and studies. In the other way, we may express investing as a process of purchasing assets with the goal of increasing financial wealth. Learning to invest on your own is the best method of self-defence in the aspect of trying to invest. That means educating yourself to the point where you can confidently manage your own money, free of the conflicts that pollute many investment products and the "advice" that sells them. An individual must learn to invest himself. He alone is motivated to manage it best. Plus, with the proliferation of investing how-to books, websites and tools on the Internet, there really is no excuse to bury ones head in the sand. Contrary to what some advisers will tell you, investing prudently does not require an advanced degree in mathematics or a special ability to forecast economic and market trends. All you need are some basic math skills, a desire to learn and the proper emotional mindset.

In fact, learning to control your emotions may be the most important skill. Though learning to invest is not an easy task, but it will not happen at all if ones don't get moving now. Even if you ultimately decide to let someone else manage your money, learning as much as you can, will help you to get the most out of your relationship and avoid becoming a victim. For example, one who used to do whatever his financial adviser recommend, would buy mutual funds with outrageously high fees or buy and sell stocks when simply holding blue-chip shares would have been a far better choice. In contrast, one who learns to invest, able to do some research to determine whether the trade is in his interest, or the adviser's and declines when it is the latter. Over relying to investment adviser might lead you down a path that leads to his or her financial well-being at the expense of yours. The more you know about investing, and the more control you take over your own money and the crucial decisions that affect your future, the less likely it will happen to you.

Case Study 2 (20 marks)

Lucy is a young Hollywood writer who is well on her way to television superstardom. After writing several successful television specials, she was recently named the head writer for one of TV’s top-rated sitcoms. Lucy fully realizes that his business is a fickle one and, on the advice of her dad and manager, has decided to set up an investment program. Lucy will earn about a half-million dollars this year. Because of her age, income level, and desire to get as big a bang as possible from her investment dollars, she has decided to invest in speculative, high-growth stocks.

Lucy is currently working with a respected Beverly Hills broker and is in the process of building up a diversified portfolio of speculative stocks. The broker recently sent her information on a hot new issue. She advised Lucy to study the numbers and, if she likes them, to buy as many as 1,000 shares of the stock. Among other things, corporate sales for the next three years have been forecasted as follows:

Year

Sales

(in millions)

2013

$22.5

2014

$35.0

2015

$50.0

The firm has 2.5 million shares of common stock outstanding. They are currently being traded at $70 per share and pay no dividends. The firm has a net profit rate of 20%, and its stock has been trading at a P/E of around 40 times earnings. All these operating characteristics are expected to hold in the future.

Looking at Lucy’s investment program in general:

(a) What risks is she facing by buying this stock? Be specific. (6 marks)

The speculative stock is a high risk stock but it also is a high return stock, which stocks can be very risky because they don’t have the fundamentals to support a higher stock price expectation. And the stock price is not stable it can go up very fast but it also can fall in few days. Investor invest this types of stock is based on the company tips and rumors which will significant influence the value of the company. If investor believe the false tips or rumors it may cause investor losses. Therefore, investor and her broker have to make sure the tips or rumors are true.

The other risk of the investor facing is it may fail to meet the whisper number. The whisper number is a number that is circulated among Wall Street insiders about a particular investment. The stock may start going up and it will beat Wall Street analysts’ prediction. If many institutional investors think that the stock would do better than what it is doing, they may decide to sell the shares in the company. A large number shares sell-off by those investors can make the stock price plummet rapidly. Only one way investor to avoid this state is know in advance what the whisper number is, otherwise there is no way to protect against this in investor’s portfolio.

The risk face by investor is obsolescence. Obsolescence risk is mean that the company has a great product or idea and it will potentially be huge in the marketplace but the product or idea was launched it to market first by other company. When this happen, the company does not make it to market with their idea could potentially become obsolete. When a company puts all of their resources into a particular project, the project need to be success. When this does not happen, it can be devastating for the company and the investors. Investor can avoid it, investor has to make sure the company has one-of-kind product or idea is in process.

(b) What do you think of her investment program? What do you see as its strengths and weaknesses? Are there any suggestions you would make? (8 marks)

Based on the information given, the investment shows that the sales amount will sign increase in next three year. This mean that the company may have great idea or product will launch in next three year. And the net profit rate is 20% which mean there will gain $0.20 in each dollar in sales. Stock has been trading at a P/E of around 40 times earnings which is mean the stock trading at a level 40 times higher than its earnings. A high P/E ratio is signify that high expectations and it is risky than low P/E ratio. From the result above, it shows it is a best investment program and we should invest it.

The strengths of the investment program are getting a high P/E ratio, which is meaning that it has great earning power and it may increase to the higher price. When it compares with other companies in the same industry is most variable. The net profit margin is intended to be a measure of the overall success of a business. A high net profit margin is indicates that the price is correctly and has good cost control. A good net profit margin is more than 10% and in this investment is 20% it is excellent. And it also can compare with the companies in the same industry is better than other. The weakness of the program is high P/E ratio, which may increase in the higher price but it also has the possibility the market force will cause the price down. The information which is given is not complete it may influence the investor decision. It should provide the recently result such as last quarter, month which can compare the past and the future. It will let the investor make a best decision in the investment program.

Based on the result above, we can conclude that the investment program is indicate a best investment and the investor should invest it but it should compare with the recently result. The investor will know the different between the past and the future.

(c) Do you think Lucy should consider adding foreign stocks to her investment? Explain. (6 marks)

Lucy should consider adding foreign stocks to her investment. But investor should consider some factor before investing foreign stocks. At first, investor should consider the currency exchange. The currency exchange will influence the investor return may rise or fall when foreign currency becomes stronger or weaker.

Next, investor need to know the government policy of the country which her want to invest. The country may set some policy and taxation of securities that could be at odds with investor investment to limit the investor, such as china. Or like India, which can direct invest in India stock market. And the country economic instability also needs to include in the consideration, like inflation. There are still have some factor need to consider, e.g. social, season.

Investors invest foreign stocks can spreads some risk over the world. At now, business happen in the whole world, therefore investor has many opportunities to choice like emerging market such as the Pacific Rim for investment and investor can spreads some of risk over a wider geographic area and multiple economies.

Case Study 3 (20 marks)

Mr. and Mrs Lim, along with their two teenage sons, live in Kampar, Perak. Mr. Lim is a sales representative for a major medical firm, and Mrs. Lim is a personnel officer at a local bank. Together, they earn an annual income of around RM100,000. Mr. Lim has just learned that his recently departed rich uncle has named him in his will to the tune of some RM250,000 after taxes. Needless to say, the family is elated. Mr. Lim intends to spend RM50,000 of his inheritance on a number of long-overdue family items ( remodelling of the kitchen, new furniture and down payment of a new car). Mr. Lim wants to invest the remaining RM200,000 in various types of fixed-income securities.

The Lim couples have no unusual income requirements or health problems. Their only investment objectives are that they want to achieve some capital appreciation, and they want to keep their funds fully invested for a period of at least 20 years. They would rather not have to rely on their investments as a source of current income but want to maintain some liquidity in their portfolio just in case.

(a) Explain to the Lim couples the basic investment attributes of bonds and their use as investment vehicles. (6 marks)

Fixed income securities is a very important investment which can diversify the portfolio of Lim couples in order to reduce risk. It is issued by government, corporation or other entity of a debt instrument for the purpose of finance and expand the operations. Fixed income securities provide a return in the form of fixed periodic payments and inevitable return of principal at maturity. Maturity date is the day the income investment is to be paid back. There are some examples of the fixed income securities which are bonds, savings bonds, guaranteed investment certificates (GICs), treasury bills, bankers acceptances, national housing act mortgage-backed securities (MBS), strip coupons and residuals, and laddered portfolio.

According to the question, Lim couples want to achieve some capital appreciation and want to maintain some liquidity in their portfolio. Obviously they are focusing on the bond investment. In finance, a bond is an instrument of indebtedness of the bond issuer to holders. The indebted entity (issuer) issues a bond that states the interest rate (coupon) that will be paid and when the loaned funds (bond principal) are to be returned (maturity date). There are two features of a bond which is credit quality and duration which are the principal determinants of a bond's interest rate.

There are 4 basic investment attribute of bonds which are safety, rate of return, liquidity and duration in order to decide the best option. All investment cannot avoid the risk. The degree of risks are varies among the investment we choose. The previous performance of an investment can help us to forecast the future performance. However it's just a good guide to indicate, it's not a guarantee. Some of the investments have a safety net to cover the investor from the comprehensive losses in the event of failure.

Investments provide the rate of return based on the level of the risk involved. The reward for owning an investment is either current income or increase in value. Generally, higher risk investments will have a higher rate of return; lower risk investments will have a lower rate of return. It is important not to be preoccupied with the rate of return without assessing its relation to safety.

A liquid investment is an investment that one has immediate access to, either the ability to buy or sell the investment or the ability to access and withdraw funds. It is how liquid you able to convert the cash or cash equivalents. . In other words, a liquid investment is tradable- there are ample buyers and sellers on the market for a liquid investment. You may hold an illiquid asset at various points in your investment horizon.

For investors, duration is an indicator of standard data point provided in presentation of comprehensive bond information. The bigger the duration number, the greater the risk and rate of return reward for the bond prices, vice versa. A good investment has a good risk-return trade-off and provides a good return-duration trade-off as well.

The investment in bonds is very safe compare to others investment. The bond promote by government is virtually guarantee or risk-free. As investment in bond is very low risk, the rate of return will become lower than other securities.

(b) Describe the type of bond investment program you think the Lim couples should follow? In answering this question, give appropriate consideration to both return and risk factors. (6 marks)

Lim couples would want to maintain some liquidity in their portfolio just in case. Hence, they would choose to invest in municipal bonds.Municipal bonds also known as munis are a step up on the risk scale from treasuries, but make up for it in tax trickery. It is issued by states, countries, cities and other political subdivision.

The returns of municipal bonds are free from federal tax. Some municipal bonds are completely tax free because of local governments make their debt non-taxable for residents. The most attractive of municipal bonds are tax-free. The interest rate of municipal bonds is lower than other similar long-term securities like treasury bills however municipal bonds take advantage of the tax-exemption. This actually levels the playing field and making these bonds more profitable than often perceived. As Lim couples mention that they would not have to rely on their investments as a source of current income but want to maintain some liquidity in their portfolio. Second, municipal bonds is extremely safe. Between 1970 and 2000, the 10-year cumulative default rate for municipal bonds was 0.04 percent.  In other words, during those 30 years, less than half of one percent of municipal bonds failed to pay back the promised interest and principle. Lim couples no need to worry about their money cannot payback in the future.

Municipal bond consists of two basic types which is general obligation bonds and revenue bonds. General obligation bonds are secured by a state or local government's pledge to use legally available resources, including tax revenues, to repay bond holders. Revenue bonds are special type of municipal bond distinguished by its guarantee of repayment solely from revenues generated by a specified revenue-generating entity associated with the purpose of the bonds.

(c) List several different types of bonds that you would recommend for their portfolio and briefly indicate why you would recommend each. (8 marks)

There are several types of bonds that can recommend for Lim couple’s portfolio such as corporate bonds and treasury bonds. Corporate bonds are debts issued by industrial, financial and service companies to finance capital investment and operating cash flow. It is higher risk of a company defaulting than a government which are defined as higher yields. Hence, corporate bonds are the most lucrative fixed-income investment because people are rewarded for extra risk when taking this bonds. The lower the company's credit quality, the higher the interest people paid. The credit quality of the companies and governments is monitored by Standard and Poor's and Moody's which help to evaluate the interest rate that company and government has to pay.

The corporate bonds provide fixed stream of income so that they are safer than stocks. The bond holders get paid by companies before the stock holders. If the company bankrupt, bong holders would be the ones to get the proceeds from auctioning off the company's assets and the stock holders would get nothing. Corporate bonds provide higher interest rates. Corporate normally offers higher yields than other bonds. However, higher risks will tends to higher returns. It has higher default risk compare to other bonds like government bonds. The Lim couples have no unusual income requirements or health problems, they are able to take the high risk investment. Lastly, corporate bonds is very liquid in the market. You can sell the bonds easily due to the size and liquidity of market.

Other variations on corporate bonds are convertible bonds and callable bonds. Convertible bonds are bonds that are issued by corporations and able to convert into shares of the issuing company’s stock at the bondholder’s discretion. Convertible bonds are typically offer but lower yields than straight corporate bonds and higher yields than common stock. Callable bond also named as redeemable bond is a type of bond that allows the issuer of the bond to retain the privilege of redeeming the bond at some point before the bond reaches its date of maturity. The bonds are not really bought and held by the issuer but are instead cancelled immediately.

Treasury bonds are the safest bond investments because they are backed by government. The U.S. treasury bonds are considered as one of the safest investments in the world. The debt of many developing countries, however, does carry substantial risk. Like companies, countries can default on payments. This bonds are classified according to the length of the time before maturity. The U.S. treasury market is the most liquid financial market in the world. It has active primary and secondary markets means investors can buy and sell bonds quickly in the market. Treasury bonds are non-callable means that investors of non-callable treasury bonds can hold them until maturity and continue to collect the high interest payments. Other than that, treasury bonds are exempted from the state income tax.

There are two types of treasury bonds which are treasury notes and treasury bills. Treasury bonds are the debt securities maturing in more than 10 years where treasury bills' maturity day are less than one year and treasury notes are maturing in one to ten years.

Case Study 4 (10 marks)

A little more than 10 months ago, Luke, a mortgage banker in Klang Valley, bought 300 shares of stock at RM40 per share. Since then, the price of the stock has risen to RM75 per share. It is now near the end of the year, and the market is starting to weaken. Luke feels there is still plenty of play left in the stock but is afraid the tone of the market will be detrimental to his position. His wife, Dena, is taking an adult education course on the stock market and has just learned about put and call hedges. She suggests that he use puts to hedge his position. Luke is intrigued by the idea, which he discusses with his broker, who advises him that the needed puts are indeed available on his stock. Specifically, he can buy three-months puts, with RM75 strike prices, at a cost of RM550 each.

(a) Given the circumstances surrounding Luke’s current investment position, what benefits could be derived from using the puts as a hedge device? What would be the major drawback? (4 marks)

i. Benefits of using puts as a hedge device

Cost efficiency

Puts may provide cost efficiency because it has great leveraging power in a stock without committing to a trade. Puts allow Luke to have leverage on his investment efficiently taking control over the fortunes of an underlying asset for a small cost of purchasing the stock. He can obtain an option position that will mimic a stock position almost identically. However, it is at a huge cost savings. In addition, he would receive the same benefit if he is going to keep the puts until its expiry date and it is in-the-money. The puts strategy known as stock replacement is not only viable but also practical and cost efficient.

Less risk

Puts have low potential risk that is limited to the option premium but there are situations in which buying puts are riskier than owning equities. However, puts can be less risky for Luke because they require less financial commitment than equities. Additionally, due to their relative imperviousness to the potentially catastrophic effects of gap openings, they can also be less risky.

If Luke purchases a put option for protection, he would not have to suffer the catastrophic loss. Because options are the most dependable form of hedge, and this also makes them safer than stocks. When Luke purchases the stocks, a stop-loss order is designed to "stop" losses below a predetermined price.

Flexible

Puts are flexible. They may provide from conservative to high-risk and can be tailored to more expectations. Furthermore, investors can take out various options combination because there are a lot of option exercise prices and expiry dates. With the right conditions, investors can sometimes take a small risk trading to get more potential returns.

ii. Major drawback

Time decay

Time always works against the put buyers and the time premium evaporates with increasing speed as the expiration date approaches. Thus, the time-sensitive nature of options leads to the result that most options expire worthless. If the stock stays flat or doesn’t move, then the puts will lose value due to time decay.

Price

Luke could experience a loss or perhaps only break even when the stock price declines and he is not enough to offset the lost time value of the puts. Therefore, the price must drop enough to produce a profit.

(b) Should Luke use the puts as a hedge? Explain. Under what conditions would you urge him not to use the puts as hedge? (6 marks)

Luke should use the puts as a hedge. He could not use the puts as hedge in the following conditions:

Puts have time decay because they are contractual agreements. They have a limited lifespan whether it is weeks, months or years, there is an expiration date and the contract is over by that date. Time is money because the closer to the expiration date a contract is written, the less chance to get Luke to meet his conditions. Therefore, when the stock stays flat or doesn’t move for a long time, better not to use puts as a hedge.

Furthermore, when the underlying stock rises instead of falls, also cannot be used as a hedge. There is the risk which Luke could lose all his money if he uses this strategy when the condition is occurs. Therefore, use the puts when the stock underpriced or when the market during a decline.

The reward and danger of leverage is especially powerfully when investors are selling naked puts or entering into any unlimited risk option strategies. Puts trading is a highly speculative venture and it has substantial risk & reward involved. Therefore, stay away from the uncertain future otherwise he would get losses.

Case Study 5 (30 marks)

Ling and Ravi are district managers for Lee Inc. Over the years, as they moved through the firm’s sales organization, they became (and still remain) close friends. Ling, who is 33 years old, currently lives in Ipoh. Ravi, who is 35, lives in Penang. Recently, at the national sales meeting, they were discussing various company matters, as well as bringing each other up to date on their families, when the subject 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, Ling said she felt the only way an individual who does not have hundreds of thousands of dollars can invest safely is to buy mutual fund shares. She 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.

Ravi totally disagreed. He said, "Diversification! Who needs it?" He felt that what one must do is look carefully at stocks possessing desired risk-return characteristics and then invest all one’s money in the single best stock. Ling told him he was crazy. She said, "There is no way to measure risk conveniently – you’re just gambling." Ravi disagreed. He explained how his stockbroker had acquainted him with beta, which is a measure of risk. Ravi 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. Ravi explained that with beta, one does not need to diversify; one merely needs to be willing to accept the risk reflected by beta and then hope for the best.

The conversation continued with Ling indicating that although she knew nothing about beta, she didn’t believe one could safely invest in a single stock. Ravi continued to argue that his broker had explained to him that betas can be calculated not just for single stock but also for a portfolio of stocks, such as mutual fund. He said, "What’s the difference between a stock with a beta, of say, 1.20 and a mutual fund with a beta of 1.20? They both have the same risk and should therefore provide similar returns."

As Ling and Ravi continued to discuss their differing opinions relative to investment strategy, they began to get angry with each other. Neither was able to convince the other that they were right. The level of their voices now raised, they attracted the attention of the company vice-president of finance, Mr. Ho, who was standing nearby. He came over and indicated he had overheard their argument about investments and thought that, given his expertise on financial matters, he might be able to resolve their disagreement. He asked them to explain the crux of their disagreement, and each reviewed their own viewpoint. After hearing their views, Mr. Ho 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 are also some errors in each of your explanations. Ling tends to support the traditional approach to portfolio management. Ravi’s views are more supportive of modern portfolio theory." Just then, the company’s president interrupted them, needing to talk to Mr. Ho immediately. Mr. Ho apologized for having to leave and offered to continue their discussion later that evening.

(a) Analyze Ling’s argument and explain why a mutual fund investment may be overdiversified. Also explain why one does not necessarily have to have hundreds of thousands of dollars to diversify adequately. (10 marks)

5a Ling’s argument is that by acquiring mutual funds, one can invest a few thousand dollars in one fund and easily obtain instant access to a diversified portfolio, instead of diversifying your portfolio by purchasing individual securities, which exposes you to more risk. A mutual fund allows an investor to diversify into many different stocks for a nominal investment. Thus, one does not necessarily have to own hundreds of dollars to diversify adequately. However, when it comes to diversification, simply own many different stocks are not good enough. For example, if you own 100 stocks within a mutual fund, and those 100 stocks are in the financial sector (a sector mutual fund), more than likely as the financial sector moves up and down, so does the value of your mutual fund. A mutual fund also allows for diversification between various styles, sectors, countries and etc. You can either buy a mutual fund that is broadly diversified, or you can buy a portfolio of mutual funds across various sectors -- creating your own diversification. In summary, a mutual fund allows for diversification between many different stocks and also allows for diversification between various sectors, styles, etc. This diversification allows investors to reduce the risk of one particular stock or sector, but also allows for more potential reward by offering a broader exposure to various stocks and sectors.

Capital can be spread across various assets by using the method of diversification in mutual funds, instead of putting a large chunk of money in one asset and bearing a sizeable loss when its value drops. By this way, when one of these investments underperforms, the negative impact on the portfolio will be muted as the other holdings will, hopefully, do well. In case of stocks, investors should invest in companies varying in size, industry and even geography. But no matter how widely diversified a portfolio, the risk can never be eliminated entirely. Thus, it is impossible to think that one will tide over the market's uncertainties by diversifications. Too much of a good thing can yield undesirable results, piling a large number of stocks and mutual funds may do more harm to your portfolio than good. Although diversification is a desirable goal for an investor, as you diversify, not only risk is reduced, but the same goes to the returns.

Over-diversification may erode the performance of your portfolio. It can leads to low impact of outperforming investments. When there are too many stocks in a portfolio, those more profitable investments may not create a meaningful value for you. As capital is spread out thinly among the different investments, the impact of a outperforming investment will turn out to be marginal. Over-diversifying might rob oneself off the gains from the good investments. Problem of plenty also arises upon over-diversification. It is cumbersome to maintain a huge portfolio and keep track of various investments. If you cannot monitor your investments regularly and need too much time to do it, you have clearly spread out thinly. In such a scenario, you may fail to notice a shift in the fundamentals of one or more of your investments. You may realise this too late, by which time the asset value could have eroded substantially.

There is a misplaced belief that with every additional security in the portfolio, the overall risk gets reduced to that extent. Studies have proved that diversification can help reduce the risk only to a certain extent. Beyond this, there is no incremental benefit. Investors might be paying more for the same. Investors often make the same mistake while purchasing mutual funds. All diversified equity funds have a basket of stocks, with the holdings spread across companies and sectors. Despite this, some investors choose to buy more and more such funds, each having at least 50-60 stocks in their kitty.They end up paying more money for funds which are picking the same set of stocks. So they are duplicating their holdings without adding any value to the portfolio. Owning too many mutual funds does not necessarily give you the underlying diversification if all the schemes own the same kind of stocks..

A mutual fund investment also may be over-diversified when one is owning too many mutual funds within any single investment style category. Some mutual funds with very different names can be quite similar with regard to their investment holdings and overall investment strategy. Investing in more than one mutual fund within any style category adds investment costs, increases required investment due diligence, and generally reduces the rate of diversification achieved by holding multiple positions. Excessive use of multi-manager investments could be another reason of over-diversifications. Multi-manager investment products, like funds of funds, can be a simple way for small investors to attain instant diversification. If you are close to retirement and have a larger investment portfolio, you are probably better off diversifying among investment managers in a more direct manner. When considering multi-manager investment products, you should weigh their diversification benefits against their lack of customization, high costs and layers of diluted due diligence. It is not your benefit to have a financial advisor monitoring an investment manager that is in turn monitoring other investment managers.

Owning an excessive number of individual stock positions

Enormous amounts of required due diligence, a complicated tax situation and performance that simply mimics a stock index, albeit at a higher cost can be leaded by owning too many individual stock positions. A widely accepted rule of thumb is that it takes around 20 to 30 different companies to adequately diversify your stock portfolio. However, there is no clear consensus on this number. Today's optimal level of diversification, measured by the rules of mean variance portfolio theory, exceeds 300 stocks. Regardless of an investor's magic number of stocks, a diversified portfolio should be invested in companies across different industry groups and should match the investor's overall investment philosophy. For example, it would be difficult for an investment manager claiming to add value through a bottom up stock-picking process to justify having 300 great individual stock ideas at one time.

Owning privately held "non-traded" investments that are not fundamentally different from the publicly traded ones you already own. Non-publicly traded investment products are often promoted for their price stability and diversification benefits relative to their publicly traded peers. While these "alternative investments" can provide you with diversification, their investment risks may be understated by the complex and irregular methods used to value them. The value of many alternative investments, like private equity and non-publicly traded real estate, are based on estimates and appraisal values instead of daily public market transactions. This "mark-to-model" approach to valuation can artificially smooth an investment's return over time, a phenomenon known as "return smoothing."

The problem with smoothing investment performance is the effect it has on smoothing volatility and possibly altering correlations with other types of assets. Research has shown that the effects of return smoothing can overstate an investment's diversification benefits by understating both its price volatility and correlation relative to other, more liquid investments. We should not be fooled by the way complex valuation methods can affect statistical measures of diversification like price correlations and standard deviation. Non-publicly traded investments can be more risky than they seem and require specialized expertise to analyze. Before purchasing a non-publicly traded investment, ask the person recommending it to demonstrate how its risk/reward is fundamentally different from the publicly-traded investments that you already own.

(b) Analyze Ravi’s argument and explain the major error in his logic relative to the use of beta as a substitute for diversification. Explain the key assumption underlying the use of beta as a risk measure. (10 marks)

Ravi disagreed with diversification. He preferred to look out for stocks possessing desired risk-return characteristics and then invest all one’s money in the single best stock. He believed that one can measure risk by beta, 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 believes he can pick stocks that have an acceptable risk level for him. Ravi explained that with beta, one does not need to diversify; one merely needs to be willing to accept the risk reflected by beta and then hope for the best. Ravi also argued that his broker had explained to him that betas can be calculated not just for single stock but also for a portfolio of stocks, such as mutual fund. He believes there is no difference between a stock with a beta, of say, 1.20 and a mutual fund with a beta of 1.20. He believes that since they both have the same risk and should therefore provide similar returns.

By investing all one’s money in the single best stock, the investors would suffer a very heavy loss when the stock price crashes. All of the risk, neither systematic risk nor unsystematic risk is unable to be reduced and are therefore all bear by the investors. Investors should not try to invest all money in one stock, it is too risky. Moreover, Ravi’s logic relative to the use of beta as a substitute for diversification is totally a wrong concept. Beta can never be a substitute for diversification as the both of them are to handle different types of risk. The risk for investment is made up of two types of investment risk, systematic and unsystematic. Systematic risk is the risk that is associated with market returns. It cannot be attributed to the specific risk of individual investments, but is attributed to broad factors. Sources of systematic risk can be macroeconomic factors such as inflation, fluctuations in currencies, changes in interest rates, economic recessions, wars, etc. In addition, an individual company cannot control systematic risk. Systematic risk can be partially relieved by asset allocation. Owning different asset classes with low correlation can smooth portfolio volatility because asset classes react differently to macroeconomic factors. Systematic risk can be partially reduced by asset allocation. Unsystematic risk is defined by company specific or industry specific risk. It is a risk attributable to the individual investment and small group of investments. Other names used to describe unsystematic risk are specific risk, diversifiable risk, idiosyncratic risk, and residual risk. Besides, unsystematic risks are considered governable by the company or industry. Next, unsystematic risk is not correlated to market risk and it can be nearly eliminated by using diversification.

Diversification is use to reduce unsystematic risk. The risk that cannot be diversified away is called Systematic risk and is measured by Beta. Since, both of them are plays in different role, therefore they cannot substitute each other.

Beta is a risk measure of non-diversifiable risk (systematic risk), it can be used to indicates how the price of a security responds to market forces. It can be used to compare the historical return of an investment to the market return (the S&P 500 Index). By definition, the beta of the market is 1.0, and individual stocks are ranked according to how much they deviate from the market. Stocks may have positive and negative betas, though nearly all are positive. Stocks with betas greater than 1.00 are more risky then the overall market, they swing more than the market over time. Stocks with betas less than 1.00 are less risky than the overall market, they move less than the market. High-beta stocks are supposed to be riskier but at the same time it also provides a potential for higher returns, while although low-beta stocks possess lesser risk but it also causes lower potential returns. If the market is expected to increase by 10%, a stock with a beta of 1.50 is expected to increase 15%. If the market went down 8%, a stock with a beta of 0.50 should only decrease by about 4%.

(c) Explain how the traditional approach and modern portfolio theory can be blended into an approach to portfolio management that might prove useful to the individual investor. Relate this to reconcile Ling’s and Ravi’s differing points of view. (10 marks)

Traditional portfolio theory is a portfolio management which practice in returns and risk. Apart from these two parameters of investment avenues, the co-relation between securities is not considered. Traditional portfolio approach to portfolio management simply involves forming a portfolio with a large variety of stocks from different industries to obtain the benefits of diversification. These are usually high-quality, well know stocks. Investors considered the risk is in totality, instead of subdivided into systematic and non-systematic. Furthermore, the traditional approach to portfolio management concerns itself with the investor, definition of portfolio objectives, diversification, and selection of individual investment. The portfolio objectives are to maximize the individual investors’ wealth which is subject to risk. Generally, investors have the concepts on the higher the level of risk borne, the more the expected returns. When the risk is low, the low or reasonable returns can be achieved.

Modern portfolio theory (MPT) is a portfolio management theory which relies on statistical concepts and attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. Based on a given level of market risk to optimize return, emphasizing that risk is an inherent part of higher reward. The main objective of this theory is to have an efficient portfolio, highest return and lowest the risk. The most popular of modern portfolio theory is the beta value and the use of correlation coefficient. This portfolio is efficiently diversified but has no diversifiable risk. It only has non-diversifiable risk and can be measured by using beta value.

Although traditional approach and modern portfolio theory are in the different way to investment strategy, but these two approaches can be combined into an approach to portfolio management that might prove useful to the individual investor. According to the discussion between Ling’s and Ravi’s, Ling’s argument is diversification. She preferred a person needs to hold a broadly diversified portfolio and that only those with a lot of money. Diversification can reduces volatility of returns and risks. Therefore, it seeks adequate equity diversification and balancing of equities against fixed interest bearing securities. However, if invest too much money on a stock may lead to over diversification. Investing a large number of stocks and mutual funds may do more harm to the portfolio than good. Diversification is a desirable goal for an investor. When investor diversify portfolio, not only reduce risk, but also the returns. Investors should form the portfolios with different types of stocks across industries for diversification and keep this trade-off in mind because over-diversification can erode the performance of portfolio. Besides, if an investor has only invest a little money in each stock, the investor may gain so small money when transaction costs and other fees are being counted into account, the investor may actually have lost money rather than gain profit. Consequently, the stock must to be negative covariance in order to get efficient diversification and then make profit.

Furthermore, as Ravi’s idea, use beta for each stock to calculate the portfolio risk. Beta of a stock or portfolio is a number to describe the correlated volatility of an asset in relation to the volatility of the benchmark that said asset is being compared to. This benchmark is generally the overall financial market and is often estimated via the use of representative indices, such as the S&P 500. It measures the part of the asset’s statistical variance. It measures the part of the asset's statistical variance that cannot be removed by the diversification provided by the portfolio of many risky assets, because of the correlation of its returns with the returns of the other assets that are in the portfolio. In addition, beta can be estimated for individual companies using regression analysis against a stock market index. When a beta is 1.0 that means the firm will react exactly as the market does. When beta more than 1.0, means the company is a more sensitive company. Otherwise, the company is a less sensitive company.

Additionally, investors should choose a portfolio based on their own risk tolerance and highest return. Investor need to consider how much cash need to commit, and just what the investment as well as financial targets tend to be. In addition, investors should have personal investment knowledge, income and asset levels, long term investment goals, and personal preferences and so on. A few priorities, such as retirement, are critical, whereas others (such as traveling around the world after retirement) are optional. The more critical an investment goal is, the less risk tolerance it can bear. Only invest as much money as investor’s deem necessary and as much money as they believe will fit into their overall asset allocation and the opportunity for long-term capital gains.