Assignment: Module Questions
1. Rational investors should not invest their entire money in a single stock (or few stocks) regardless of how highly-recommended that stock is by professional financial analysts. Investors are better off investing their money in a diversified manner to cut down investment risk and to get a better risk-return tradeoff. Explain whether this makes financial sense and state your financial arguments for or against diversification. Also, state what percentage of the overall risk (SD) of a NYSE-listed average stock can be eliminated through diversification according to your book. Limit your answers to no more ten sentences.
2. If investors become more jittery (more risk-averse) about investing in the stock markets based on new growth fears about the U.S. and global economies, then what will happen to current stock prices and expected stock returns according to the predictions of the Capital Asset Pricing Model (CAPM)? Also, some may describe CAPM in a simple, non-technical way that it rewards investors for "waiting and worrying about their investments". Discuss what CAPM variables may correspond to the waiting and worrying part of your invested money. Limit your answers to no more fifteen sentences.
3. If you invest your entire capital in a biotechnology sector mutual fund or biotech exchange traded fund (ETF) with 50 biotech stocks in each fund, then you would have eliminated all of the company-specific risks and your portfolio will be almost fully diversified. Explain whether or not this is a valid diversification argument according to the discussion in Chapters 6 and 25. Limit your answers to no more ten sentences.
4. Chapter 25 explains that it is better for investors to have part of their money invested in a risk-free asset. Remember that the return (reward) to risk ratio from the new efficiency frontier with the risk-free asset (CML) is better than from the old efficiency frontier with no risk-free asset. Explain why this the addition of a risk-free will lower the overall portfolio risk and raise reward to risk ratio. Limit your answers to no more ten sentences.