Case: Flirting with Risk

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Brief Background

It was about three months when the husband of Mary Owen, Ralph Owen, has

passed away. Mary’s husband left behind a small fortune which he earned when he was

alive. For over 30 years, Ralph Owen worked in an engineer profession wherein he

earned plenty of benefits from the company’s retirement saving plans. Ralph had a

portfolio investment composed of stocks from 3 different companies (Utility Company,

High-Teach Company, and Counter-Cyclical Company). Fortunately, these investments

of Ralph had quite a significant growth and a good return on investments.

On the other hand, Mary devoted all her life as a mother who just stays at home,

focused on family matters, and take care of her children. Unlike Ralph who used to

manage all the financial affairs of their family, Mary is a conservative, risk-averse, and

clueless about investment matters and decisions that have to be made. After the death of

her husband, she came to realize that she is unprepared and knew nothing about decision-

making when it comes to being responsible for their wealth.

Upon the advice of a friend, Mary asked at a brokerage company for the

assistance of the firm’s senior financial adviser who is Bill May to help her understand

the complexity of investments matters and assist her in deciding what to do, what plan of

action to be made to balance and control the value of their wealth.

Mary let Bill run through their portfolio during the first meeting. As a financial

adviser, he was shocked with how narrowly focused its composition had been. He

discovered that Ralph is a type of investor who likes to flirt with risk because as he saw

on the investment portfolio, its value had lost almost 30%. So far, Bill came into an idea

which is to diversify first the portfolio and lowering its beta. Bill as a financial adviser, is

a better idea given the status in the life of Mary and that they don’t need to flirt with the

risk that much, unlike Ralph. However, Mary is a bit clueless about what terms Bill is

talking about. Apparently, Bill settles another appointment with Mary to give her

knowledge about risk, returns, and how to manage an investment portfolio.

Statement of the Problem

An investment Portfolio is a set of financial assets owned by an investor, which is

Ralph, in this case, that may include bonds, stocks, currencies, cash and cash equivalents,

and commodities. However, upon the death of Ralph, the investment portfolio was left to

Mary his wife. To have growing returns, knowledge about the financial market is needed.

A financial market is a place where firms and individuals enter into contracts to sell or

buy a specific product such as a stock, bond, or futures contract. Buyers seek to buy at the

lowest available price and sellers seek to sell at the highest available price. There are

several different kinds of financial markets, depending on what you want to buy or sell,

but all financial markets employ professional people and are regulated. Mary as a full-

time mother these concepts is new to her so the main problem is how will Mary handle

the situation, specifically, in managing the portfolio investment even if she is clueless

about investment matters?

Point of View

The point of view of this case study is of Bill May who is a senior financial advisor

suggested by Mary’s friend. An effective financial advisor makes recommendations on

how can a client improve their financial life. As for the case of Mary Owen, she is not

knowledgeable on how to maximize the wealth that her husband left and is not confident

in making decisions for her husband’s investment. Bill may see the ignorance of Mary as

an obstacle that will greatly affect in terms of financial planning. Hence, his first

objective is to educate Mary on how does corporate finance works. Moreover, with Bill

May’s help, Mary will be able to distinguish what is a better investment portfolio and can

further make better decisions using the data that is shown in the portfolio.

Areas of Consideration
1. Explaining to Mary the terminologies/concept used in financial market.

Mary, the wife of Ralph, was a very conservative and cautious person. She

is a stay-at-home mother devoted to raising their children, Jim and Annette. As a

couple who is enjoying their married life, Ralph is the one who managed almost all

the financial affairs of the family while Mary focuses on other family matters.

Furthermore, Mary was not exposed to financial markets and when Ralph passed

away, she was unprepared to manage one’s wealth. Bill as a financial advisor, his

first responsibility is to explain and help Mary understand the terminologies/

concept used in the financial market to better understand the investment portfolio

Ralph left.

2. Investment portfolio left by Ralph – stocks of three growth companies

Bill as a financial advisor, will assess the financial problem of individuals

and help them with the decision on investments. Ralph's investment portfolio has

grown to $900,000 comprised of the stocks of three companies and appreciated

significantly over time. Billy examined the portfolio that was left by Ralph and he

noticed that it had lost almost 30% of its value. Hence, Billy decided to diversify its

portfolio and lower its beta but unfortunately, Mary has no idea how the financial

market works. Billy needs to explain the factors that could affect the investment

decision on Ralph’s investment portfolio in the financial market such as inflation

rates, interest rates, beta and etc.

3. Formulas or computation used to manage an investment portfolio

Mary as being clueless about the financial markets and how does it work.

Bill’s job is to base on all the formulas and computations to be used in finding the
 best combination that should be proposed to Mary. By identifying the options of best

combination, Bill will be able to explain to Mary what are the risk or the chance of

financial loss and measure the returns or the total gain or loss on investment of each

option. As a financial advisor, Bill can give Mary some tips on which of the options

she should take to improve the management of the investment portfolio left by his

deceased husband. Investors like returns and dislike risk so Mary would probably

prefer a combination that has gradually growing returns.

Alternative Course of Action

The alternative course of action pertains to the determined options that will answer

the problem, in this case, Mary Owen’s cluelessness in managing the portfolio

investment. The first alternative course of action is to assess a portfolio with better risk

and return management. By doing the first ACA, Mary will learn how to make decisions

using the data in the portfolio. The second alternative course of action is to present and

explain the advantages of diversification by showing comparisons to know which

investments are deemed best. Lastly, the financial advisor will construct a well-analyzed

ratio of the portfolio to help Mary in managing the investments without the burden of

great risk.

Analysis of Alternative Course of Action

I. Quantitative Analysis
50% 50% Expected Standard
Scenario Probability High-tech Counter – Returns Return Deviation
(P) (H) cyclical (r) (^r ¿
(B) (H + B) ( r^ ∗P) ¿
Recession 20% -5% 20% 7.50% 1.50% 0.000198
Near 20% 2% 16% 9% 1.80% 0.000054
Recession

Normal 30% 15% 12% 13.50% 4.05% 0.000244

Near boom 10% 25% -9% 8% 0.80% 0.000070

Boom 20% 45% -20% 12.50% 2.50% 0.000068

10.65% =0.000634

√ 0.000634
2.52%
Table 1.1- Expected Return and Standard Deviation Comprises 50% each of High-Tech
Company’s Stocks and Counter- Cyclical Company’s Stock.

High-tech Counter –
cyclical
15.4% 5.9%
Expected return
17.69% 15.69%
Standard deviation
a. Construct investment with Lower risk.
Table 1.2 - Expected Return and Standard Deviation Comprises of High-Tech
Company and Counter- Cyclical Company.
b. To further explain the advantages of diversification and help Mary think

critically, Bill May opted to illustrate 2 different options.

Illustration 1: Finding the expected return and standard deviation of a

portfolio that comprises 50% of high-tech stocks and 50%

of counter cyclical stocks. (Refer to Table 1.1 for

computations)

Illustration 2: Finding the expected return and standard deviation of a

70% 30% Expected Standard

Scenario Probability High-Tech Index fund Returns Return Deviation

 (P) (r) (^r ¿

(H + I) ( r^ ∗P) ¿
Recession 20% -5% -2% -4.10% -0.82% 0.006415362

Near 20% 2% 5% 2.9% 0.58% 0.002380562

Recession
Normal 30% 15% 10% 13.50% 4.05% 0.000002883
Near 10% 25% 15% 22% 2.20% 0.0006707761
boom
Boom 20% 45% 25% 39% 7.80% 0.012690722
13.81% =0.0221603051

√0.0221603051

14.89%
portfolio that comprises 70% of portfolio in the High-Tech

stocks and 30% in the Index Fund.

Table 2 - Expected Return and Standard Deviation Comprises 70 % stocks of High-

Tech Company and 30% from Index Fund

c. To build an investment portfolio with a combination of 30:30:40 among 3

different companies: Counter Cyclical Co., Utility Company, and High-

tech Company.

30% 30% 40% Expected Standard

Scenario Probability High- Counter- Utility Returns Return Deviation

(P) tech Cyclical company (r) (^r ¿

(H) (C) (U) (H + I) ( r^ ∗P) ¿

Recession 20% -5% 20% 6% 6.9% 1.38% 0.000200978

Near 20% 2% 16% 7% 8.2% 1.64% 0.000069938

Recession
Normal 30% 15% 12% 9% 11.7% 3.51% 0.000079707

Near 10% 25% -9% 11% 9.2% 0.92% 0.000007569

boom
Boom 20% 45% -20% 14% 13.1% 2.62% 0.000183618

10.07% =.00054181

√.00054181

2.33%
Table 3. Combination of 30:30:40 among Counter-Cyclical Co., Utility Company

and High-Tech Company.

II. Qualitative Analysis

Mary as being clueless about the terms used in financial markets. As a

financial advisor, the first thing that Bill needs to explain is the terms that are

being used. The following are the terms and concepts used in managing and

analyzing the investment portfolio:

1. Risk is the chance of financial loss and is used interchangeably with

uncertainty to refer to the variability of return associated with a given

asset. Moreover, Assets having greater chances of loss are viewed as

risky than those with lesser chances of loss.

2. Returns are commonly measured as cash distributions of total gain or

loss experienced on an investment over a given period of time. To

 assess risk, we must know the meaning of return is and how to

measure it.

3. Standard Deviation is to indicate the riskiness of an asset that

measures the dispersion around the expected value. When prices

increase, the standard deviation is high, meaning, investments will be

risky and if the standard deviation is low, it means that prices are

moderate. Hence, investments come with low risk.

Furthermore, these terms and concepts were used in analyzing the quantitative

and qualitative narrative above. Below is the analysis of each alternative course of action.

a. Construct investment with Lower risk.

Diversification reduces the portfolio’s variability and thereby enables

investors to earn a more stable rate of return. Since High-tech Co. and

Counter-cyclical Co. are negatively correlated with each other, Bill

demonstrated the advantages of diversification by calculating the expected

return which is the predicted total gain or loss experienced on an investment

over a given period. Moreover, Bill calculated the risk or the chance of

financial loss such as standard deviation that indicates the riskiness of the

assets which measures the dispersion around the expected value of these

investments in one portfolio. The data in Table 1.1 and 1.2 show that a

portfolio comprised of equal investments in the High-Tech Company and

Counter-Cyclical would provide an expected rate of return that would be in

between the returns of the two stocks with an expected risk level that would

be much smaller than either of the two stocks’ expected standard deviation.

b. Illustration 1: Finding the expected return and standard deviation of a

portfolio that comprises 50% of high-tech stocks and 50% of counter

cyclical stocks.

Diversification is the process of allocating capital in a way that

reduces the exposure to any one particular asset or risk. A diversified

portfolio includes different kinds of assets that work because uncorrelated

assets react differently with each other. When investments in one area

perform poorly, other investments in the portfolio can offset losses.

Illustration 2: Finding the expected return and standard deviation of a

portfolio that comprises 70% of portfolio in the high-tech stocks and 30%

in the index fund.

As illustrated in Table 2 , the 70%:30% portfolio that is composed

of high-tech and index fund would not necessarily be better for Mary,

since it has much higher expected level of risk (14.89% versus 2.52%) and

only a slightly higher level of expected return (13.81% versus 10.65%)

visa vis the 50%:50% portfolio of High-tech and the Counter-cyclical. By

presenting these portfolios to Mary, she can now understand how risk is

related to returns and learn how to make use of the information to improve

decision making. The first illustration is deemed the better portfolio.

c. To build an investment portfolio with a combination of 30%:30%:40%

among 3 different companies: Counter Cyclical Co., Utility Company, and

 High-tech Company.

As Mary has agreed that she doesn’t need the high risk given her

status in life, Billy come-up with this diversified portfolio. Although this

portfolio is already a better option, it still has its weaknesses like low

returns compared to the 50%:50% portfolio but this only happens because

the risk is also low. The relationship between risk and return is direct that

is why the higher the risk, the higher the return, and vice versa. This

portfolio has a 2.33% of standard deviation (risk) which is not bad for a

10.07% return.

Conclusion and Recommendations:

The most important thing about being an investor is to know the level of

diversification of one’s investment portfolio. Diversification is holding investments that

will react differently to the same market or economic event. For instance, when the

economy is growing, stocks tend to outperform bonds. But when uncertain things may

happen and one sector will drop its value, the risk is more likely bearable and the chances

of losing an investment are shallow unlike putting all your eggs in one basket. If

investments were to put in 5 sectors wherever one of the sectors is dropping down, the

other sectors would be harmless and offset the losses in that sector. Diversification is

designed to help investors balance or limit their risk exposure. Most of the investors have

successful investments because they know how to manage their comfort level with risk.

For Mary Owen, the main problem here is her given status in life and she doesn’t
have any exposure to investing matters. Bill’s advice of diversifying the portfolio and

lowering its beta to Mary does necessarily make sense to her at first given her situation.

Although Bill would make sure that Mary will soon gain knowledge about this matter and

terminologies. This advice of Bill will help Mary minimize her overall portfolio from the

risk of loss and she will be exposed to more opportunities for returns. In diversifying the

portfolio, Bill and Mary have to choose among three alternative courses of action which

is (1) to construct investment with Lower risk., (2) To further explain the advantages of

diversification and help Mary think critically, Bill May opted to illustrate 2 different

options, and (3) to have an investment portfolio combination of 30:30:40 among 3

different sectors: Counter-Cyclical Co., Utility Company, and High-tech Company.

Weighing the three courses of action, Bill can recommend and propose the third

option which is to have 30%:30%:40% investment on Counter Cyclical Company, Utility

Company, and High-tech Company since it has a least standard deviation of 2.33 with a

good expected rate of return among others. Although when you compare it with

quantitative analysis of two standard deviations, the difference is quite small and it also

bears a good return however what Bill prioritizes here is a combination of an investment

portfolio that carries a much lower risk. Option in illustrations 1 and 2 both have a good

return, however, both also have a standard deviation that is higher than alternative

courses 1 and 3. High standard deviation equals higher risk, as what has been stated

above, option 3 has the least standard deviation which means it has lower risk and it

would be an ideal decision for the investment portfolio of Mary. That is why Option 3

should be used for a much more successful investment, it deals a low risk with a fine
expected return.