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.