Question: Traditional Versus Modern Portfolio Theory: Who's Right?

Walt Davies and Shane O'Brien are district managers for Lee, Inc. Over the years, as they moved through the firm's sales organization, they became (and still remain) close friends. Walt, who is 33 years old, currently lives in Princeton, New Jersey. Shane, who is 35, lives in Houston, Texas. Recently, at the national sales meeting, they were discussing various company matters, as well as bringing each other up to date on their families, when the subject of investments came up. Each had always been fascinated by the stock market, and now that they had achieved some degree of financial success, they had begun actively investing. As they discussed their investments, Walt said he thought the only way an individual who does not have hundreds of thousands of dollars can invest safely is to buy mutual fund shares. He emphasized that to be safe, a person needs to hold a broadly diversified portfolio and that only those with a lot of money and time can achieve independently the diversification that can be readily obtained by purchasing mutual fund shares.

Shane totally disagreed. He said, "Diversification! Who needs it?" He thought that what one must do is look carefully at stocks possessing desired risk-return characteristics and then invest all one's money in the single best stock. Walt told him he was crazy. He said, "There is no way to measure risk conveniently-you're just gambling." Shane disagreed. He explained how his stockbroker had acquainted him with beta, which is a measure of risk. Shane said that the higher the beta, the more risky the stock, and therefore the higher its return. By looking up the betas for potential stock investments on the Internet, he can pick stocks that have an acceptable risk level for him. Shane explained that with beta, one does not need to diversify; one merely needs to be willing to accept the risk reflected by beta and then hope for the best. The conversation continued, with Walt indicating that although he knew nothing about beta, he didn't believe one could safely invest in a single stock. Shane continued to argue that his broker had explained to him that betas can be calculated not just for a single stock but also for a portfolio of stocks, such as a mutual fund.

He said, "What's the difference between a stock with a beta of, say, 1.2 and a mutual fund with a beta of 1.2? They have the same risk and should therefore provide similar returns." As Walt and Shane continued to discuss their differing opinions relative to investment strategy, they began to get angry with each other. Neither was able to convince the other that he was right. The level of their voices now raised, they attracted the attention of the company's vice president of finance, Elinor Green, who was standing nearby. She came over and indicated she had overheard their argument about investments and thought that, given her expertise on financial matters, she might be able to resolve their disagreement. She asked them to explain the crux of their disagreement, and each reviewed his own viewpoint. After hearing their views, Elinor responded, "I have some good news and some bad news for each of you. There is some validity to what each of you says, but there also are some errors in each of your explanations. Walt tends to support the traditional approach to portfolio management. Shane's views are more supportive of modern portfolio theory." Just then, the company president interrupted them, needing to talk to Elinor immediately. Elinor apologized for having to leave and offered to continue their discussion later that evening.

a. Analyze Walt's argument and explain why a mutual fund investment may be overdiversified. Also explain why one does not necessarily have to have hundreds of thousands of dollars to diversify adequately.

b. Analyze Shane's argument and explain the major error in his logic relative to the use of beta as a substitute for diversification. Explain the key assumption underlying the use of beta as a risk measure.

c. Briefly describe the traditional approach to portfolio management and relate it to the approaches supported by Walt and Shane.

d. Briefly describe modern portfolio theory and relate it to the approaches supported by Walt and Shane. Be sure to mention diversifiable risk, undiversifiable risk, and total risk, along with the role of beta.

e. Explain how the traditional approach and modern portfolio theory can be blended into an approach to portfolio management that might prove useful to the individual investor. Relate this to reconciling Walt's and Shane's differing points of view.