Question: Briefly describe modern portfolio theory andrelate it to the approaches supported by Walt and Shane. Be sure tomention diversifiable risk, undiversifiable risk, and total risk,along with the role of beta.
Walt Davies and Shane O’Brien are district managers for Lee,Inc. Over time, as they moved through the firm’s salesorganization, they became close friends. Walt, who is 33 years old,currently lives in Princeton, New Jersey. Shane, who is 35, livesin Houston, Texas. Recently, they were discussing various companymatters, as well as bringing each other up to date on theirfamilies, when the subject of investments came up. Each had alwaysbeen fascinated by the stock market, and now that they had achievedsome degree of financial success, they had begun activelyinvesting.
As they discussed their investments, Walt said he thought theonly way an individual who does not have hundreds of thousands ofdollars can invest safely is to buy mutual funds. He emphasizedthat to be safe, a person needs to hold a broadly diversifiedportfolio and that only those with a lot of money and time canachieve independently the diversification that can be readilyobtained by purchasing mutual fund shares.
Shane disagreed. He said, “Diversification! Who needs it?” Hethought that what one must do is look carefully at stockspossessing desired risk-return characteristics and then invest allone’s money in the single best stock. Walt told him he was crazy.He said, “You’re just gambling.” Shane disagreed, explaining howhis stockbroker had acquainted him with beta. Shane said that thehigher the beta, the more risky the stock, and therefore the higherits return. By looking up the betas for potential stock investmentson the Internet, he can pick stocks that have an acceptable risklevel for him. Shane explained that with beta, one does not need todiversify; one merely needs to be willing to accept the riskreflected by beta.
The conversation continued, with Walt indicating that althoughhe knew nothing about beta, he didn’t believe one could safelyinvest in one stock. Shane continued to argue that betas apply notjust to a single stock but also to mutual funds. He said, “What’sthe difference between a stock with a beta of, say, 1.2 and amutual fund with a beta of 1.2? They have the same risk and shouldprovide similar returns.”
As Walt and Shane discussed their differing opinions relative toinvestment strategy, they began to get angry. Neither was able toconvince the other that he was right. Their voices now raised, theyattracted the attention of the company’s vice president of finance,Elinor Green, who was nearby. She came over and said she hadoverheard their argument and thought that, given her expertise onfinancial matters, she might be able to resolve their disagreement.After hearing their views, Elinor responded, “I have some good newsand some bad news for each of you. There is some validity to whateach of you says, but there also are some errors in each of yourexplanations. Walt is right that diversification reduces risk.Shane is right that a mutual fund and a stock having the same betashould produce the same return.” Just then, the company presidentinterrupted them, needing to talk to Elinor immediately. Elinorapologized for having to leave and offered to continue theirdiscussion later that evening.
