lOMoARcPSD|18500269

Flirting with Risk Final.pdf

Finance (University of Negros Occidental-Recoletos)

Studocu is not sponsored or endorsed by any college or university

Downloaded by Jaja Jiji (jjiji5118@gmail.com)
 lOMoARcPSD|18500269

Flirting with Risk

A Study Submitted to the Faculty of College of Business and Accountancy

In Fulfilment of the First Case Study in
Financial Markets

Felix Cena, CPA, MBA

Professor, FINMA2_E
University of St. La Salle

De Los Angeles, Karlo Jay

Lorca, Jazeia Joy
Montaño, Juan Miguel
Ortega, Catherine Joy
Proponents, COAS 2A

UNIVERSITY OF ST. LA SALLE

Bacolod City, Negros Occidental
Western Visayas - Region VI

February 13, 2021

Downloaded by Jaja Jiji (jjiji5118@gmail.com)

 lOMoARcPSD|18500269

BACKGROUND OF THE CASE

Ralph Owens is an engineer for a surgical instruments manufacturer who invested in 3 high growth

companies. Since he lived a thrifty life and knew how to properly utilize his retirement savings,

his investment portfolio grew into a positive amount of $900,000 brought by the numerous stock-

splits of the prices of the 3 companies which appreciated significantly over the years. However,

due to unfortunate events, he passed away and left his small but sustainable fortune to his wife,

Mary Owens. Correspondingly, Mary is not knowledgeable regarding finances for she lived a

conservative life and enjoyed the roles of being a housewife. Moreover, their children are already

established so the investment was all up for her to handle.

In the light of her crisis, Agnes, a kindred friend, recommended her current financial advisor named

Bill May. Upon hearing about Bill’s good feedback, Mary decided to hire him and ask for his

advice regarding his late husband’s fortune and how to properly handle it. Bill May immediately

studied Owen’s portfolio and found out that Ralph Owen’s investments were not diversified and

has actually has a narrow composition. Furthermore, he discovered that the portfolio lost 30% of

its value because of the drop in the technology sector. Since the data reflected a high risk, Bill

decided it would be best to diversify the portfolio and lower the beta. Additionally, the case further

showed a table comprised of various rates of return depending on different scenarios.

Downloaded by Jaja Jiji (jjiji5118@gmail.com)

 lOMoARcPSD|18500269

POINT OF VIEW

Since the case is focused on how to modify the investment portfolio of the Owen’s, the

proponents will assume the point of view of the senior financial adviser, Bill May. He was

recommended by Mary’s friend because she found him helpful with regards to balancing and

reallocating her portfolio, leading to its increase over the years. In this light, the proponents will

be using the necessary pronouns in the analysis as if in place of Bill May.

STATEMENT OF THE PROBLEM

The study focuses on identifying the possible ways or measures that Mary Owens must

do in order for her to learn, identify, and choose the right decisions regarding her late husband’s

investments. Moreover, along with the help of the proponents being the financial advisors, the

study aims to answer the following questions:

• What necessary actions are needed in order to optimize the investment?

• What is the best way for Mary to handle and manage the investment portfolio?

Downloaded by Jaja Jiji (jjiji5118@gmail.com)

 lOMoARcPSD|18500269

AREAS OF CONSIDERATION

This aspect will present significant parts that were analyzed by the financial advisers and

shall further manifest the key concepts needed throughout this paper. Correspondingly, it will

reflect the facts, difficulties, and other data needed in order to feasibly and realistically create

better decisions regarding the investment.

• Mary’s level of knowledge about the financial markets.

Since she is a conservative stay at home parent focused on her children, it would be difficult

for her to make sound and reasonable decisions because of her lack of knowledge and skills

regarding finance. Moreover, her personality, skills, and experiences as an individual was limited

to the other side of household matters such as chores and being a housewife.

• The background and experiences of their children

It was emphasized in the case that her children have finished their education and were

working in different fields with stable and established lives. In this light, it is substantial for us,

as the financial advisors, to remember the priority of the client and find solutions relating to her

important needs. Moreover, since her son is pursuing MBA in a business school, it should be

taken into account that his knowledge about the financial markets may help Mary in making

decisions.

• Factors affecting decision making.

As financial advisors, we understand that the amounts inside the investment is the only

substance needed in order to increase the gains. Inflation risk, interest rates, economic

conditions, and government policies may interfere with the flow of stocks. Moreover, the

Downloaded by Jaja Jiji (jjiji5118@gmail.com)

 lOMoARcPSD|18500269

technology sector mentioned in the case is also on the verge of either succeeding or failing

leading for the team to consider this area.

• Different formulas and computations for the investment portfolio

Since the client has little background with finance, all of the computations would be a

challenge for her to understand and it is our responsibility as financial advisors to simplify and

discuss the amounts with her. Furthermore, we would be dealing with beta, expected returns, and

standard deviations; all of which are not something a housewife deals with on a daily basis.

• Knowledge and level of expertise of Bill

Bill’s background and knowledge about the financial markets should be taken into

consideration because his examination and advice affect the decision making of Mary. Moreover,

the stated financial advisor has good feedbacks from his past client and it shows that with his

skills and professionalism, he is capable of handling investments from 3-high growth companies.

Comparatively, since we, the proponents, will take his place we also keep in mind that the

decisions we make in this study shall be feasible and relevant.

Downloaded by Jaja Jiji (jjiji5118@gmail.com)

 lOMoARcPSD|18500269

ALTERNATIVE COURSES OF ACTION

Basis for the Alternative Courses of Action

Index Fund Utility Company High Tech Company Counter Cyclical Company
Expected Rate of 5.90 % 9.20 % 5.00 % 5.90 %
Return
Standard 11.75 % 2.82 % 23.56 % 15.09 %
Deviation
Covariance - 0.00302200 0.027600 -0.0144
(Rs,Rm)
Beta 1.0 0.211847178 1.934805468 -1.011636873

Required Rate of 2.10 % 3.95 % 3.56 % 4.23 %

Return
Calculations for this table is found in Appendix A and Appendix B

Prior to the exploration of the various alternative courses of action, the financial advisers

first identified the expected return and standard deviation of the three stocks in the investment

portfolio. Each stock had probability percentages in relation to the scenarios in the economy

along with its rate of return if the economic state occurs. Moreover, the standard deviation

quantifies the tightness of the probability distribution. The smaller the standard deviation, the

less it will deviate from the expected return, the lower the risk.

On the other hand, beta measures the expected move in a stock in relation to movements

in the overall market. Basically, it measures the change in the stocks from the overall market. A

beta higher than 1.0 shows that the stock is more volatile than the overall market which makes it

riskier, as compared to a beta less than 1.0 which indicates a stock with lower volatility that

poses less risk. Higher beta means its riskier but provides higher return as opposed to a low beta

which is less risky subject to lower returns.

Downloaded by Jaja Jiji (jjiji5118@gmail.com)

 lOMoARcPSD|18500269

Alternative Courses of Action

After determining the areas of consideration in Mary’s perspective, as a financial adviser, we

would like to suggest some course of actions in order for her to manage and work well with her

investments. The courses of actions are the following:

• Gather Counter-Cyclical and High-Tech Company stocks of a 50/50 ratio.

• Invest in the index fund and treasury bills.

• Create a 70/30 portfolio composed of High-Tech Stocks and Index Fund

• Develop a portfolio of 50/50 ratio composed of Utility Company and Counter-Cyclical

Company.

Downloaded by Jaja Jiji (jjiji5118@gmail.com)

 lOMoARcPSD|18500269

ANALYSIS OF THE ALTERNATIVE COURSES OF ACTION

50% Counter-Cyclical and 50% High-Tech Company

Portfolio High-Tech Counter- 50%/50% 50%/50% variance 50/50
Company Cyclical Expected Rate of Standard
- Company Rate of Return Deviation
Expected - Return
Return Expected
Return

Expected -5.00% 4.00% -0.50% -2.50% 12.6405%

Return
-4.00% 3.20% -0.40% -2.00% 11.1005%
4.50% 3.60% 4.05% 13.50% 19.4408%
2.50% -0.90% 0.80% 8.00% 0.6503%
7.00% -4.00% 1.50% 7.50% 0.8405%
5.00% 5.90% 5.45% 24.50% 44.6725% 6.683749

A diversified portfolio is the best way to reduce risk through careful calculation of the

factors affecting the rates and return. The best way to reduce the risk of your stock portfolio is to

choose stocks that are not closely correlated with each other. Stocks that behave differently with

regards to the market and inflation will go well together and will still bring you interest income

despite recessions. This is the advantage when one stock responds poorly in one period while the

other is earning better interest which in turn reduces the portfolio’s beta which is its volatility.

By developing a 50/50 stock portfolio of Counter-Cyclical and High-tech Company, the

expected return would be 5.45% and a deviation of 6.68%. This alternative course of action

would provide less risk than investing in one of the companies. Counter-Cyclical’s standard

deviation alone is 15.09% while High-tech company resulted to a 23.56%. Investing in one of the

companies alone will be much riskier since there is a bigger possibility that their return will

deviate far from the expected return. The portfolio beta consisting of the two companies will also

Downloaded by Jaja Jiji (jjiji5118@gmail.com)

 lOMoARcPSD|18500269

be lower than their respective stand-alone beta which is 0.23 and -0.12. A negative beta is more

favorable; however, it is best to balance it out with a stock that performs differently during

market fluctuations and the beta alone will not assure great return. Together, the portfolio beta is

0.055 which is less volatile than the average stock.

Invest in Index Fund and Treasury Bills

Mary, who is a more conservative and cautious person, may want to lean towards

investing in more low-risk securities that will slowly but surely bring income from stocks. Index

funds and treasury bills are examples of investments that do not fluctuate as much with the

market. Their beta is relatively low and is more consistent than others. The beta of index funds is

at an average of 1 and a standard deviation of 11.75% and the treasury bills have a beta of zero.

Index funds are made to mirror a market’s index which is used by investors as benchmarks for

their portfolios. They are proven to provide more stable growth in stocks for long-term and safe

investing, however, there is less flexibility within this type of investing than managed portfolios

because the fund managers experience constraints because of the specific policies they have to

adhere to. Another disadvantage is that index funds will not likely outgrow the market the way

you can manage your own portfolio. There will be no huge gains with index funds. Treasury bills

or T-bills are also low-risk securities that are short-term in nature. They are safer kinds of

investments similar to investing in index funds but they are short-term which means that if they

mature in a time where interest rates go up you have to reinvest with a much more expensive cost

of capital.

Downloaded by Jaja Jiji (jjiji5118@gmail.com)

 lOMoARcPSD|18500269

30% Index Fund and 70% High-Tech Company

Scenario Probability High-Tech Index Fund 70-30 Portfolio Prob.*E(Portfolio) {[Rp-E(Rp)]^2}*Ps

Co.
Recession 20% -25% -10% -20.50% -4.10% 0.013281858
Near Recession 20% -20% -6% -15.80% -3.16% 0.008878898
Normal 30% 15% 12% 14.10% 4.23% 0.002339067
Near Boom 10% 25% 15% 22.00% 2.20% 0.002798929
Boom 20% 35% 20% 30.50% 6.10% 0.012731058
ExpectedReturn 5.00% 5.90% 5.27%
Standard 24.19% 11.94% 20.01%
Deviation

The 70-30 portfolio composed of High-Tech Company and Index Fund shows that both

stocks are positively correlating with each other. This means that they move together within the

market and when one investment has losses the other mirrors the same. However, when one

investment gains, the other also does the same. In line with this, the combination becomes way

too risky for someone like Mary who does not need too much of a gain. Correspondingly, it was

shown that this portfolio’s standard deviation will also drastically escalate to 20.01% while its

expected rate of return lowered to 5.27% as compared to the 50/50 ratio of High Tech and

Counter-Cyclical Company.

Downloaded by Jaja Jiji (jjiji5118@gmail.com)

 lOMoARcPSD|18500269

50% Utility Company and 50% Counter-Cyclical Company

Porfolio Counter- Utility 50%(utility co) 50%/50% variance Portfolio

Cyclical Company /50%(counter) Rate of Standard
Expected Rate Return dev
of Return

rate of return 4% 1.2% 2.60% 13.00% 0.18%

3% 1.4% 2.30% 11.50% 0.13%
4% 2.7% 3.15% 10.50% 0.14%
-8.9% 1.1% -3.90% 1.00% 0.01%
-4% 2.8% -0.60% -3.00% 0.09%
Expected 5.90% 9.20% 3.55% 33.00% 0.54% 7.36%
return
standard dev 11.75% 2.82%
beta portfolio -0.4

The third alternative course of action is a stock portfolio comprising a 50/50 ratio of

Utility Company and Counter-Cyclical’s stocks. This combination is negatively correlated which

becomes an excellent advantage because the losses on the other investment can be covered by

the gains on the other investment. Moreover, the portfolio arrived at a negative beta of -0.4

which is much more favorable than other portfolios calculated and as well as a low standard

deviation of 7.36% that proves that the rate of return will not deviate too far from the expected

rate of return. This means that the stocks together within the portfolio moves slowly alongside

the market changes. A portfolio with the smallest beta achievable will reduce risk that is more

acceptable to a cautious and conservative beginner investor like Mary.

Downloaded by Jaja Jiji (jjiji5118@gmail.com)

 lOMoARcPSD|18500269

RECOMMENDATION AND CONCLUSION

Mary Owens as a widowed house wife who do not have any knowledge in managing

stocks or portfolio left by her husband, she needs to take care of it and have some knowledge to

take care and manage this portfolio. The portfolio consists of different stocks from different

company such as Treasury Bill with an expected rate of return of 4%, Index fund of 5.90%,

Utility Company of 9.20%, High-Tech Company of 5% and Counter Cycling Company of

5.90%. All of them has different expected rate of returns, this means that all of them has different

interest rates. Some of them has a high interest and some has low, that leads that the portfolio

needs to be diversified because the interests can be weighted average that leads to low interest,

meaning low risk for the portfolio.

Furthermore, beta measures the expected move in a stock in relation to movements in the

overall market. Basically, it measures the change in the stocks from the overall market. Higher

beta means its riskier but provides higher return as opposed to a low beta which is less risky

subject to lower returns. The best possible portfolio combination that we, as financial advisers,

may suggest to Mary is to evenly invest on Utility Company and Counter Cyclical Company.

This decision was derived due to the fact that both stocks are undervalued which means they

both have lesser risk. Moreover, they are also negatively correlated which becomes an excellent

advantage because the losses on the other investment can be covered by the gains on the other

investment. Correspondingly, upon computing the portfolio on both stocks, the data showed that

this combination leads to a negative beta (-0.4) which reflects that it is less volatile so the assets

are less risky than average. Its standard deviation is also not extremely high (7.36%) which again

reflects lower risk but this does not disable her investment from gaining because her expected

return is also positive which is a good evidence that she will still be gaining money.

Downloaded by Jaja Jiji (jjiji5118@gmail.com)

 lOMoARcPSD|18500269

With regards to Mary Owens’ managing the investments of his husband, we, as the

financial advisers highly suggests that before investing in a company, she should do some

research about the company and the industry that her stocks would be entering into. Undervalued

stocks are not a bad investment. In fact, undervalued stocks have a future potential to rise up. It

is highly recommended to by undervalued stocks because aside from she can purchase it at a low

cost but eventually, when the stocks are recognized in the respective market and industry it

would result to instant profit. And after gaining profit she can sell it and save the proceeds and

invest it into a fine-income security for her to have a stable return.

Downloaded by Jaja Jiji (jjiji5118@gmail.com)

 lOMoARcPSD|18500269

APPENDICES

Appendix A – Expected Return and Standard Deviation

Downloaded by Jaja Jiji (jjiji5118@gmail.com)

 lOMoARcPSD|18500269

We find the expected return of each stock by multiplying the probability of each

scenarios to the rate of return if the economic state occurs, and afterwards get the sum. As for the

standard deviation, we first find the deviations by subtracting the expected return of each stock to

the rate of return if the economic state occurs accordingly. After finding the deviations, the

deviations are squared and then multiplied to the probability in relation to their scenarios. After

getting the results, we get the sum to find the variance. Finally, we find the square root of the

variance to get the standard deviation. This process is performed to each stock to find its

respective standard deviation.

Appendix B – Beta, Covariance, Required rate of return

Downloaded by Jaja Jiji (jjiji5118@gmail.com)

 lOMoARcPSD|18500269

REFERENCES

Diversification. (n.d.). Investopedia.

https://www.investopedia.com/terms/d/diversification.asp#:%7E:text=Diversification%2

0is%20a%20risk%20management,any%20single%20asset%20or%20risk.

Expected Return Definition. (2009). Investopedia.

https://www.investopedia.com/terms/e/expectedreturn.asp

Gresham, T. (2017, November 21). What Are the Primary Advantages & Disadvantages of Index

Mutual Funds? Finance - Zacks. https://finance.zacks.com/primary-advantages-

disadvantages-index-mutual-funds-4030.html

James Royal. (2021, February 1). Diversification In Investing: Here’s Why It’s So Important For

Your Money. Bankrate. https://www.bankrate.com/investing/diversification-is-important-

in-investing/

Lander, S. (2019, February 1). Advantages & Disadvantages of Treasury Bills. Pocketsense.

https://pocketsense.com/advantages-disadvantages-treasury-bills-

7493.html?fbclid=IwAR2x_lDRdckyAAYQBwvhNiNF8sK8eUhjgB0afM05djRjbCOB4

6J14TqS5UM

S. (2020, February 27). Beta Formula. EDUCBA. https://www.educba.com/beta-

formula/?fbclid=IwAR2EPDhsUO8am-

4fIM2DBOV7Qp5GYeCOZna_ZjAiQ_kQIfn8mYAN_X1TQk0

Downloaded by Jaja Jiji (jjiji5118@gmail.com)

 lOMoARcPSD|18500269

Undervalued Stocks - Factors, Advantages and Disadvantages of Undervalued Stocks. (2020,

May 13). Groww. https://groww.in/p/undervalued-stocks/

Downloaded by Jaja Jiji (jjiji5118@gmail.com)