Modern Portfolio Theory and Diversification

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Systematic risk is the risk that affects the overall stock market. The most obvious example in this scenario is the recent news by the RBA (Reserve Bank of Australia) to keep the interest rate at a low 1.5%. This caused a rise in the stock price. There is seen to be an inverse relationship between stock prices and interest rates, since there tends to be a substitution effect between the two securities (Alam & Uddin, 2009). When interest rates are high, investors tend to hold bonds and when rates are low, they either hold cash or stocks. Interest rate movement is classified as systematic risk as it affects the entire stock market, and the investor cannot diversify it away by adding more stocks into their portfolio. Another event that can be considered as systematic risk is global price movement. On 5th September, North Korea tested a missile near the Japanese airspace. The following morning, global markets slightly slumped in response to the announcement by American President Donald Trump, suggesting that he would take appropriate measures against the North Korean aggression. The Dow Jones index fell, and the ASX followed (Imbert, 2017).

Recommendation

Given an amount of $10,000, it would certainly be wiser to invest in the S&P500 index, or its ETF (exchange traded fund) called Spyder. The S&P500 index has historically been one of the best performing indices on the stock market, averaging almost 8% annual return since the 1890s’. As a comparison, the least risky instrument available to the investor are 1 year U.S. Government Treasury Bills. The S&P500 index has a premium that is much higher, considering the risk that it carries (Mehra & Prescott, 2003).

There are a number of theories that investors and analysts use to pick a stock. According to Malkiel (2007), it is impossible for an individual investor to beat the stock market. For a short amount of time, a company may outperform the index, but it will always return to the long run average of the market return. If Boral is currently performing better than the market, then we can see from historical trends that it must face a correction in the future. A stock may be overvalued or undervalued. If it exceeds its true book value per share, then investors will soon realize this and will sell once they are able to realize their profits. Most financial analysts would agree that the “putting your eggs in one basket” strategy is rarely effective. In the long run, diversification always leads to maximized returns. However, this choice is also dependent on the individual investor and their risk preference. A risk-averse investor will choose the diversified portfolio, whereas a risk taker might choose to invest in the single security in hopes of beating the market (Rabin, 2000). However, looking at diagram 1, it is evident that Boral is underperforming compared to the index, so investment in it is currently not a good idea.

References

Pfaff, B. (2012). Modern portfolio theory. Financial Risk Modelling and Portfolio Optimization with R, 46-53.

Alam, M. D., & Uddin, G. S. (2009). Relationship between interest rate and stock price: empirical evidence from developed and developing countries.

Richter, A., Schommer, M., & Karna, A. (2017, January). The Performance Effects of Diversification in the Context of Its Decline: A Meta-Analytical Review. In Academy of Management Proceedings (Vol. 2017, No. 1, p. 13813). Academy of Management.

Fischer, D. E., & Jordan, R. J. (1975). Security analysis and portfolio management. Prentice Hall.

Malkiel, B. G. (2007). A random walk down Wall Street: the time-tested strategy for successful investing. WW Norton & Company.

Rabin, M. (2000). Risk aversion and expected‐utility theory: A calibration theorem. Econometrica, 68(5), 1281-1292.

Boral Ltd. (2016). Boral Ltd. Annual Report. Retrieved from: www.boral.com.au/annual-reports- 2016

Mehra, R., & Prescott, E. C. (2003). The equity premium in retrospect. Handbook of the Economics of Finance, 1, 889-938.

Imbert, F. (2017, September 5). Dow closes more than 200 points lower, posts its worst day since August 17. Retrieved from: www.cnbc.com