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 small fortune, which he had accumulated by living a very
thrifty life and by investing in common stocks. Ralph had worked as an
engineer for a surgical instruments manufacturer for over 30 years and
had taken full advantage of the company's voluntary retirement savings
plan. However, instead of buying a diversified set of investments he had
invested his money into a few high growth companies. Over time his
investment portfolio had grown to about $900,000 being primarily
comprised of the stocks of 3 companies. He was very fortunate that his
selections turned out to be good ones and after numerous stock-splits
the prices of the three companies had appreciated significantly over
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 their
two kids into finc adults, each of whom had a fairly successful career.
Jim, 28, had followed in Ralph's footsteps. In addition to being
gainfully employed as an engineer, he was pursuing an MBA at a
prestigious business school. Annette, 26, was completing her residency
at a major metropolitan hospital. Although Mary and Ralph had enjoyed a
wonderful married life, it was Ralph who managed almost all the
financial affairs of their family. Mary, like many spouses of their
generation, preferred to focus on other family matters.
It was only after Ralph's passing on that Mary realized how unprepared
she was for the complex decisions that have to be made when managing
one's wealth. Upon the advice of her close friend, Agnes, Mary decided
to call the broker's office and request that her account be turned over
to Bill May, the firm's senior financial advisor. Agnes, a widow
herself, had been very happy with Bill's advice and professionalism. He
had helped her rebalance and re-allocate her portfolio with the result
that her portfolio's value had steadily increased over the years without
At their first meeting, Bill examined the Owens' portfolio and was
shocked at how narrowly focused its composition had been. In fact, just
during the past year --due to the significant drop in the technology
sector --the portfolio had lost almost 30% of its value. "Ralph,
certainly liked to flirt with risk," said Bill. "The first thing we are
going to have to do is diversifY your portfolio and lower its beta. As
it stands you could make a lot of money if the technology sector takes
off, but the reverse scenario could be devastating. I am sure you will
agree with me that given your status in life you do not need to bear
this much of risk." Mary shrugged her shoulders and looked blankly at
Bill. "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 to
me how the risk level of my portfolio can be lowered?" Bill realized
right away that Mary needed a primer on the risk-return tradeoff and on
portfolio management. Accordingly, he scheduled another appointment for
later that week and prepared the following exhibit to demonstrate the
various nuances of risk, expected return, and portfolio management.
1. Imagine you are Bill. How would you explain to Mary the relationship
between risk and return of individual stocks?
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
3. How should Bill demonstrate the meaning and advantages of
diversification to Mary?
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
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