Diversification within a Portfolio


Diversification within a Portfolio

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Question 1

Diversification is a risk management strategy that uses a wide range of investments within a portfolio.  A diversified portfolio has a variety of unique asset types mixed and investment vehicles to limit the exposure to any risk or a single asset. The technique applied under this kind of rationale is that a portfolio is constructed using various kinds of assets will, that will contribute to long-term returns and reduce the risk of any security or personal holding. The importance that comes with diversification is that it minimizes the risk of losses, for example, if one of your investment projects performs poorly in a certain period, other investments are likely to do better; thus, lowering the overall losses of your investment portfolio because capital has been concentrated in different investments. Diversification also helps in preserving capital, for instance, individuals close to the retirement age are likely to set goals aimed at preserving capital, thus, diversification helps them to protect their savings (Fama, Eugene, French, Kenneth, 2004). Another reason for diversification is that it helps in generating returns, at times investments fail to achieve their set goals as they expected, through diversification, an individual depends on several sources of income. The type of fund that benefits from diversification is the exchange-traded funds which are regarded as open-ended investments that expose a portfolio of investments that comprise a certain index. Some strategies do not seek high diversification such as repurchase agreements because they are usually short-term. Repurchase agreements play an essential role in the pricing of derivative insecurities because they allow for short positions to be taken in bonds. The most effective concept of diversification is the modern portfolio theory (MPT) which is used to determine the efficient frontier used to optimize it to achieve its goals. The main issue is to obtain maximum returns depending on the amount of risk taken. A portfolio of assets, optimization of stocks and assets to ensure returns are accrued for a particular risk. MPT uses asset allocation and periodic rebalancing to optimize portfolios. The typical examples of assets classes include equities and fixed-income and debts. Equities refer to ownership, for instance, when one buys a certain percentage of shares in a company; therefore, he owns some part of it which makes one have rights to a portion of the company’s profits. Fixed income and debts occur when purchasing bonds, which is essentially lending money. It means that an individual will pay the loan at an interest rate (Maginn, Tuttle, Pinto & McLeavey, 2007).

Question 2 (I)

Portfolios are diversified to protect against the risk of single securities, thus a portfolio analysis entails analyzing it as a whole than depending exclusively on security analysis.  The risk-return profile of security relies largely on the security itself on their allocation and the extent of their degree of correlation. A portfolio’s objective is to increase capital gains or income or both. A growth-oriented portfolio comprises several investments selected for price appreciation potential and income-oriented portfolio deals with investments identified for their present income of interest or dividends. The selection of investments depends on an individual’s tax bracket, the need for current income, ability to bear risks regardless of the risk-return objectives. An efficient portfolio comprises investments that aim at providing a significant return for risk. An investor needs to understand how the risks and returns are calculated and work towards regulating the risks through diversification. Risk and return are correlated, the different types of risks include, industry-specific risk, international risk, competitive risk, project-specific risk, while returns are losses or gains made from trading security. Industry-specific risks are those that are related to a particular industry such as insurance company which are impacted by market shifts, international risk depends on international transactions and the likely risks like nonpayment from foreign buyers (Schwartz, Robert & Robert, 2003). Competitive risks prevent an individual from attaining a goal and it is linked with the risk of declining revenues in a business because of the competitor’s actions. Project-related risks are common because they are associated with other risks like cost due to poor estimation, the other risks include, market risk, operational risk, legal, and strategic risks. The type of expected returns that the capital asset pricing model captures is dividends and capital appreciation of the stock over a certain expected period. The type of risk and return that one is exposed to is the systemic risk which focuses on the market-wide factors that make returns move in the same direction.

Question 2 (II)

Fiat money is a type of currency that does not have intrinsic value and it is estimated through government regulation as a legal tender. The other type of money is commercial bank money, commodity, fiduciary, and representative money (Elton, Gruber, Brown, Goetzmann, 2014). Fiat money such as the US dollar that has the advantage of being a good currency because it can handle the monetary roles of the nation. Its disadvantage is that it can face a financial meltdown that can result in serious recessions. Representative money represents real money, for example, land titles. It is easy to use since it is portable and its disadvantage is that it does not represent an accurate value.

Question 3 (I)

In preparation for the interview as a portfolio manager, I would do background research on the company, talk about the specificities that relate to the job position I am applying for. I will also showcase my past experiences and achievements both professionally and individually to make my employer get interested. I will also ensure that I respect their time and illustrate the reasons why I am applying for the position of portfolio manager. I would represent job reports and recommendation that I have earned over the years because it would show my performance and competencies based on performance appraisal. The metric that will be used to measure my performance is the customer reviews, returns on investments made, personal reviews, and sales (Maginn, Tuttle, Pinto & McLeavey, 2007).

Question 3 (II)

As a portfolio manager, I would not advocate for keeping money in cash because I would be easily tempted to take it as an opportunity to invest in personal projects which would affect the smooth running of a company’s activities for diverted money. I will start determining how I will save for retirement and instead of ensuring that stock picking is done, I would start mixing the stocks, bonds, and mutual funds that I would desire to hold. I would invest in land in risks that could be avoided if I do not have funds to hold. The risk associated with dividing assets will be felt over time because each one of them will exhibit different behaviors. For example, one asset category may experience appreciation while the other depreciates significantly because I must have funds to hold. To protect the investment from such a risk, it is important to keep the money in my hands to benefit the whole organization rather than an individual. The risks associated with keeping a cash portfolio is the credit risk whereby the company is likely to fall into financial difficulties and cannot repay the interest at maturity. Also, the inflation risk is likely to be experienced because the company will eventually lose the purchasing power since it cannot accommodate the adequate purchase of goods and services (Masters, Seth, 2003). Equity risk will also be experienced because the variations experienced in the market prices varies with time, therefore, the inability of company to cope up with changing times because past mistakes would result in a drop in the market price of shares. As a portfolio manager, I would not want to keep cash in my portfolio because it is easy to divert it to suit other goals and personal fulfilments that would in the end impact the company negatively.

Question 4 (I)

Immunization within portfolio management is a strategy that intends to mitigate the risks that match with the period of liabilities and assets to enable minimization of the effect caused by interest rates changes on the net worth over time. An immunization example includes, cash flow matching, for example, an investor needs to pay $20000 within five years. An investor can take the opportunity to immunize himself against the cash flow by purchasing a security that will guarantee a $ 20000 inflow for the five years. Duration matching is used to immunize a bond portfolio by applying the duration method (Chan, Louis, Jegadeesh & Lakonishok, 1999). In this immunization strategy, an investor is required to match the portfolio’s period to the time horizon in question. It can be done by buying a zero-coupon bond that will mature within the set period, purchase many other coupon bonds that have the stated duration, and lastly by many coupon bonds that average to the set period. In a fixed strategy immunization can be achieved by ensuring cash flow matching, trading forwards, duration matching, complexity matching, futures and options for bonds to avoid financial risks like exchange rate risks. The type of fund that applies immunization is the pension fund which requires a regular rebalancing of the interest rates because of its dynamism. The bonds purchased are meant to achieve a particular investment objective thus the need for close monitoring and doing adjustments where necessary.

Question 4(II)

Tracking error is a measure of financial performance that determines the difference between return fluctuations in an investment portfolio and return fluctuations of a chosen benchmark. A portfolio manager running a strategy whose tracking error is zero indicates that the performance of the portfolio near the performance of the benchmark. Low tracking errors show a high success rate and the index funds are similar to those of the main market indices (Masters, Seth, 2003). A low tracking error is preferred because the performance of the portfolio is close to the benchmark, while a high tracking error reveals a significant difference in the performance of the benchmark which indicates less success.



Chan, Louis, Jegadeesh, N., & Lakonishok, J. (1999). ‘‘The Profitability of

Momentum Strategies.’’Financial Analysts Journal. Vol.55,No.6:80–90.

Elton, E. J., Gruber, M. J., Brown, S. J. & Goetzmann, W. N. (2014). Modern Portfolio

Theory and Investment Analysis (ninth edition) Publisher: Wiley & Sons.

Fama, Eugene F; French, Kenneth R. (2004). “The Capital Asset Pricing Model: Theory and

Evidence”. Journal of Economic Perspectives. 18 (3): 25–46

Maginn, J. L., Tuttle, D. L., Pinto, J. E. & McLeavey, D. W. (2007). Managing Investment

Portfolios: A Dynamic Process, Publisher: Wiley & Sons.

Masters, Seth J. (2003). ‘‘Rebalancing.’’ Journal of Portfolio Management. Vol. 29, No. 3:


Schwartz, Robert, & Robert Wood. (2003). ‘‘Best Execution: A Candid Analysis.’’ Journal

of Portfolio Management. Vol. 29, No. 4: 37–48.

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