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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
Case 17 Flirting with RiskRisk and ReturnFlirting with RiskWhen Mary Owens' husband, Ralph, passed away about three months ago heleft behind a small fortune, which he had accumulated by living a verythrifty life and by investing in common stocks. Ralph had worked as anengineer for a surgical instruments manufacturer for over 30 years andhad taken full advantage of the company's voluntary retirement savingsplan. However, instead of buying a diversified set of investments he hadinvested his money into a few high growth companies. Over time hisinvestment portfolio had grown to about $900,000 being primarilycomprised of the stocks of 3 companies. He was very fortunate that hisselections turned out to be good ones and after numerous stock-splitsthe prices of the three companies had appreciated significantly overtime.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 theirtwo kids into finc adults, each of whom had a fairly successful career.Jim, 28, had followed in Ralph's footsteps. In addition to beinggainfully employed as an engineer, he was pursuing an MBA at aprestigious business school. Annette, 26, was completing her residencyat a major metropolitan hospital. Although Mary and Ralph had enjoyed awonderful married life, it was Ralph who managed almost all thefinancial affairs of their family. Mary, like many spouses of theirgeneration, preferred to focus on other family matters.It was only after Ralph's passing on that Mary realized how unpreparedshe was for the complex decisions that have to be made when managingone's wealth. Upon the advice of her close friend, Agnes, Mary decidedto call the broker's office and request that her account be turned overto Bill May, the firm's senior financial advisor. Agnes, a widowherself, had been very happy with Bill's advice and professionalism. Hehad helped her rebalance and re-allocate her portfolio with the resultthat her portfolio's value had steadily increased over the years withoutmuch volatility.At their first meeting, Bill examined the Owens' portfolio and wasshocked at how narrowly focused its composition had been. In fact, justduring the past year --due to the significant drop in the technologysector --the portfolio had lost almost 30% of its value. "Ralph,certainly liked to flirt with risk," said Bill. "The first thing we aregoing to have to do is diversifY your portfolio and lower its beta. Asit stands you could make a lot of money if the technology sector takesoff, but the reverse scenario could be devastating. I am sure you willagree with me that given your status in life you do not need to bearthis much of risk." Mary shrugged her shoulders and looked blankly atBill. "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 tome how the risk level of my portfolio can be lowered?" Bill realizedright away that Mary needed a primer on the risk-return tradeoff and onportfolio management. Accordingly, he scheduled another appointment forlater that week and prepared the following exhibit to demonstrate thevarious nuances of risk, expected return, and portfolio management.Questions:1. Imagine you are Bill. How would you explain to Mary the relationshipbetween risk and return of individual stocks?2. Mary has no idea what beta means and how it is related to therequired return of the stocks. Explain how you would help her understandthese concepts.3. How should Bill demonstrate the meaning and advantages ofdiversification to Mary?4. Using a suitable diagram explain how Bill could use the securitymarket line to show Mary which stocks could be undervalued and which maybe overvalued?5. During the presentation. Mary asks Bill "Let's say I choose a welldiversified portfolio, what effect will interest rates have on myportfolio?" How should Bill respond?6. Should Bill take Mary out of investing in stocks and preferably putall her money in fixed-income securities? Explain.7. Mary tells Bill, "I keep hearing stories about how people have madethousands of dollars by following their brokers' 'hot tips.' Can yougive me some hot tips regarding undervalued stocks?" How should Billrespond?8. If Mary decided to invest her money equally in high-tech andcounter-cyclical stocks, what would her portfolio's expected return andrisk level be? Are these expectations realistic? Please explain.9. What would happen if Mary were to put 70% of her portfolio in theHigh-Tech stock and 30% in the Index Fund? Would this combination bebetter for her? Explain.10. Based on these calculations what do you think Bill should propose asa possible portfolio combination for Mary?
