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Case 17 Risk and return (Flirting with risk)

1. Imagine you are Bill. How would you explain to Mary the relationship between risk and
return of individual stocks?
If I were Bill, I would explain to Mary that there would be a positive correlation between risk
and return or in other words, getting involved in high risk investment may have a greater chance
getting high return from it. However, there is no evidence that shows taking greater risk will
100% results in getting higher return but may result in other way round which is losing a large
amount of money invested. Thus, in short, investing in lower risk investment will have lower
potential for profit while investing in high risk investment will have higher potential for profit
but at the same time, also have high potential for loss profit too.
2. Mary has no idea what beta means and how it is related to the required return of the
stocks. Explain how you would help her understand these concepts.
I would explain to her that Beta is a measure of the volatility, or systematic risk, of a security or
a portfolio in comparison to the market as a whole. If a beta is 1, this indicates that the security
price will move with the market. If the beta greater than 1, it means the security price is more
volatile than the market but if beta less than 1, the security will less volatile than the market.
Therefore, under Capital Asset Pricing Model (CAPM), high-beta stocks should result in getting
higher returns to compensate investors for taking higher risk.
3. How should Bill demonstrate the meaning and advantages of diversification to Mary?
Diversification is a risk management technique that mixes various types of investments within a
portfolio. Bill can explain to Mary through example as below:
Lets assume that Benjamin who works for Company ABC which is a healthcare based company
have a total of $1 million to invest. For Benjamin, he got 2 choices. First, invest all the $1
million into his employers stock or second, diversified it by investing half of the $1 million in
his employers stock and another half in Company PQR, a beverage stock.
Given that after 3days, the stock price for Company ABC drop from $4 to $2 while the stock
price for Company PQR increase from $5 to $6.50.

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First alternative
$1,000,000 / ($4-$2) = $500,000
From here, we can see that Benjamin portfolio has losses half of his investment value or 50% of
it and ended up left only $500,000.
Second alternative
$500,000 / ($4-$2) = $250,000
{$500,000 X [($6.50-$5) / $5]} + $500,000 = $650,000
Total $250,000 + $650,000 = $900,000

So, if Benjamin chooses the second alternative, although he also incurs losses from choosing this
alternative, but his just loss $100,000 from the portfolios. It is because, although he loss
$250,000 by investing in his employers stock but at the same time, he gain profit of $150,000
from investing in Company PQR. Therefore, it is better for Benjamin to choose the second
alternative as he total up losses just $100,000 but if he chooses first alternative, his total losses
would be $500,000.
Then, Bill can tell Mary that advantage of diversification is that it can help to balance up the
unsystematic risk events occurs in a portfolio where positive performance of some investment
can help neutralize the negative performance of others investment.

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4. Using a suitable diagram explain how Bill could use the security market line to show
Mary which stocks could be undervalued and which may be overvalued?
A security market line (SML) is a line that graphs the systematic or market risk versus the return
of the whole market at a certain point in time where x-axis representing the risk (beta), and the yaxis representing the expected return.

The equation for SML is:

SML : E(Ri) = Rf + i [ E(RM) Rf]
Where:
E(Ri) is an expected return on security
E(RM) is an expected return on market portfolio M
is a non-diversifiable or systematic risk
RM is a market risk
Rf is a risk-free rate
Diagram above shows that all the correctly priced securities are plotted on the SML. From
diagram, we can see that there are some asset is plotted above the line and some below the line.
Asset plotted above the line represent that they are undervalued and those plotted below the line
is overvalued. The asset is undervalued because of the given amount of risk (beta), they yield a

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higher return while asset that are overvalued is because of the given amount of risk, and they
yield a lower return. In other words, asset that its expected returns are higher than their required
returns are considered as undervalued while asset that its expected return is lower than their
required return are considered as overvalued.
5. During the presentation, Mary asks Bill Lets say I choose a well-diversified portfolio,
what effect will interest rates have on my portfolio? How should Bill respond?
Bill can explain to Mary that the stock prices depend on the company profitability. If investors of
a certain company think that the company could not cope up with the lost profit due to the
increase in additional interest expense, then the stock price may drop. Thus, if there is a rising in
interest rate, the return of Marys well-diversified portfolio will decrease by as much as the
market index does. In other way round, if there is a decrease in interest rate, the return of Marys
well-diversified portfolio will increase by as much as the market index does.
6. Should Bill take Mary out of investing in stocks and preferably put all her money in
fixed-income securities? Explain.
Bill should advise Mary to stay investing in well-diversified portfolio of stock. Although fixedincome securities can be seen as safe as its carry lower risk, but they generally offer low returns.
Besides, fixed income-securities such as Treasury bonds will charge the investors for
withdrawing their premiums before maturity. But, if Mary holds on investing in well-diversified
portfolio of stock, Mary can increase the stability of her investments and decrease the risk of
losing money in the event if one of the stock decrease in value.
7. Mary tells Bill, I keep hearing stories about how people made thousands of dollars by
following their brokers hot tips. Can you give me some hot tips regarding undervalued
stocks? How should Bill respond?
Bill should advise Mary not to be too dependable on so call hot tips when making an
investment. It is because the tips given do not 100% guarantee that profit can be gain for that
investment. Yes, there is a possibility that the hot tips might be true and can help the investors to
gain profit easily but it also because of luck. If the hot tips gather is not true, it can cause the

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investors to incur greater losses from the investment. Therefore, it is better for Mary to make her
own research and analysis on the company she may interested in before investing on it.
8. If Mary decided to invest her money equally in high-tech and counter-cyclical stocks,
what would her portfolios expected return and risk level be? Are these expectations
realistic? Please explain.

Scenario
recession
near
recession
normal
near boom
boom
expected
return
standard
deviation

Probabilit
y
20%
20%
30%
10%
20%

CounterHigh-Tech Cyclical
Company Company
-25%
20%
-20%
15%
25%
35%

16%
12%
-9%
-20%

5%

5.90%

23.55%

15.10%

50-50
portfoli
o
-2.50%

50-50
expected
rate of
return
-0.500%

50-50
standard
deviation
0.001264

-2%
13.50%
8%
7.50%

-0.400%
4.050%
0.800%
1.500%

0.00111
0.001944
0.000065
0.000084

5.45%
0.45%

If Mary invests her money equally in High-Tech Company and Counter-Cyclical Company
stocks, the expected return of the portfolio would be 5.45% while its expected standard deviation
would be 0.45%. Above expectations only will be as realistic as the numbers used in calculating
them. Therefore, in order to get a realistic expected return estimates, Mary should make a
realistic assumptions regarding to the probabilities and returns.

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9. What would happen if Mary were to put 70% of her portfolio in the High-Tech stock and
30% in the Index Fund? Would this combination be better for her? Explain.

Probabilit
y

HighTech
Compan
y

Index
Fund

70-30
portfoli
o

70-30
expecte
d rate
of
return

recession
near
recession

20%

-25%

-10%

-20.50%

-4.10%

20%

-20%

-6%

-15.80%

-3.16%

normal

30%

15%

12%

14.10%

4.23%

near boom

10%

25%

15%

22.00%

2.20%

boom
expected
return

20%

35%

20%

30.50%

6.10%

5%

5.90%

23.55%

11.75%

Scenario

standard
deviation

70-30
standar
d
deviatio
n
0.01328
2
0.00887
9
0.00233
9
0.00279
9
0.01273
1

5.27%

4.00%

If Mary were to put 70% of her portfolio in the High-Tech Company stock and 30% in the Index
Fund, her portfolio expected level of risk will be much higher (4% versus 0.45%) as compared to
the 50-50 portfolio of High-Tech Company and the Counter-Cyclical Company. Thus, this 70-30
combination is not suitable for Mary.
10. Based on these calculations what do you think Bill should propose as a possible
portfolio combination for Mary?
Based on the calculation made above, Bill should propose Mary to have investing in the portfolio
combination of 50% High-Tech Company and 50% of Counter-Cyclical Company. Using these
portfolio combinations, Mary would have a lower expected level of risk.