Reference no: EM133001070

As we are experiencing the aftermath of some of the worst economic conditions in America since late 1920's and early 30's, we are not far removed from the financial meltdown of 2008-2009 and the carnage it created, especially in the housing sector. The likely outcome for many back then was probably lower valuations of property, or lower portfolio investment value, with recovery in the years that came after. Now, in the midst of what is most certainly a new recessionary era (despite massive stock market performance due to government intervention), we face uncertainty and the speed during which this happened has raised volatility in most asset types and raises serious questions about one of the cornerstones of financial theory, diversification.

That takes us to the second week's discussion topic, which relates to the subject of risk and diversification. In chapter 6, you start reading about portfolio composition and the importance of putting together a diversified portfolio, risk aversion, risk diversification, etc. However, the book also states that simply putting together stocks with high correlation, regardless of number of stocks, will not achieve desired diversification, because you would still be exposed to similar industry risk, despite owning companies that are not similar at all.

The discussion question is as following: is this assumption correct when it comes to creating a portfolio with companies in the same industry, such as the financial industry? Can you put together a portfolio of diverse financial companies, such as Wells Fargo (WFC), Citi (C), JP Morgan Chase (JPM) and Bank of America (BAC) all in the same industry, yet so different in what they do, and be confident that you have achieved diversification in your portfolio?

You might just dismiss it by saying they are all banks and all banks have suffered and someone with a portfolio consisting of just financial companies would not be even slightly diversified; however, I would like to point to the contrasting paths of now defunct Bear Sterns, Washington Mutual and the definitely much more prosperous Chase and Bank of America, same industry but no exact correlation in their performance.

You have plenty of research material to look at. Start by looking at the development of the stock prices for Wells Fargo, Citi, Chase and Bank of America. How have they performed in the past, most recent years, and now during the most recent crisis? How have they performed compared against each other? Again, the question that are you to answer, in detail and backed with data points and concrete facts is, "can you achieve a diversified portfolio by holding companies in the same industry, the financial industry?" Your book at different chapters says mostly no, but feel free to argue against that.