Page 255 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes Diversification

The insurance principle illustrates the concept of attempting to diversify the risk involved in a
portfolio of assets (or liabilities). In fact, diversification is the key to the management of portfolio
risk because it allows investors to minimize risk without adversely affecting return.
Random or naïve diversification refers to the act of randomly diversifying without regard to
relevant investment characteristics such as expected return and industry classification. An investor
simply selects a relatively large number of securities randomly – the proverbial "throwing a
dart at The Wall Street Journal page showing stock quotes."

Case Study Building a Recession-Proof Investment Portfolio

ith economists forecasting tough times ahead, David's 2009 New Year resolution
was to build an investment portfolio that would be able to withstand a bout of
Wmarket volatility. David was a UK citizen aged 45 and hoped that if he could
grow his investment steadily over the next five years, he would be able to build up a nice
nest egg before retirement.
David had £10,000 to invest, which was currently in a high street instance access account
(In UK, a high street account means ‘very common’. High street instant access accounts are
common savings account with a facility that allows customer to withdraw cash whenever
he needs, without paying any penalities. This makes it similar to savings bank account in
India). He wanted to protect his savings should he entered into a recession. Also, he
expected a defensive portfolio with very little risk to savings, but with some potential for
growth for next five years. Here's how, with the help of an Independent Financial Adviser
(IFA) David constructed his portfolio.
Stockmarket Volatility
Normally a well-diversified investment portfolio would have a major allocation to equities.
However, following five years of equity market growth, the current turmoil poses some
tough choices for investors like David who are looking to build a portfolio from scratch.
Equities are no longer looking such good value.

At the start of 2008, the FTSE 100 index of top UK companies was at a healthy level of 6,500.
By the end of October the index had fallen by 3,000 points. There's no indication yet that
the recent market volatility will be ending anytime soon.
By the end of 2008 the index was at 4,300. Equity markets are expected to continue to
struggle during 2008. Therefore, David decided that he wanted to make sure that the bulk
of his portfolio was in less risky investments.
David said "If I was twenty years younger, I would probably be more willing to take on
riskier assets, as with markets looking to be quite cheap now, it's probably a great time to
be investing."
"Sadly, at my age I can't afford to take any chances. I'm more interested in making sure my
money is there when I need it to be."

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