Jack O’Boyle and David O’Brien are district managers for C&M Inc., a leading supplier of construction equipment. Over the years as they moved through the firm’s sales organization they became, and still remain, close friends. Jack, who is 33 years old, currently lives in Newark, New Jersey; David, who is 35 years, 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 investment came up. Each of them had always been fascinated by the stock market and now they have achieved some financial success, they have begun actively investing. As they discussed their investments, Jack indicated that he felt that only way an individual who did not have hundreds of thousands of dollars to invest can safely is buy mutual funds shares, since they contain a large number of securities representing the stocks of the leading firms in a broad cross-section of industries. Jack emphasized that in order to be safe, a person need to hold a broadly diversified portfolio and that only those with a lot of money and time can achieve the needed diversification that can be readily obtained by purchasing mutual fund shares.
David totally disagreed. He said, “Diversification! Who needs it?” He felt that what one must do is to look carefully at each stock possessing desired risk-return characteristics and then invest all one’s money in that stock. Jack told him he was crazy. He said, “There is no way to conveniently measure risk- You are just gambling.” David disagreed. He explained how his stockbroker has acquainted him with beta, which is a measure of risk. David said that higher the beta, the more risky the stock, and therefore higher will be its return. By looking up the betas for potential stock investments in his broker’s beta book, he can pick socks having an acceptable risk level for him. David explained that with beta, one does not need to diversify; one merely need to be willing to accept the risk reflected by beta and then hope for the best. The conversation continued, with Jack indicating that although he knew nothing about beta, he did not believe one could safely invest in a single stock. David continued to argue that his broker had explained to him that beta 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 beta of say, 1.20 and mutual fund with beta of 1.20? They both have the same risk and should therefore provide a similar return.”
As Jack and David 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 voice now raised, they attracted the attention of the company vice-president of finance, Jordan Katz, who was standing nearby. He came over to Jack and David and indicated he had overheard their argument about investments and thought that, given his expertise in financial matters, he might be able to resolve their disagreement. He asked them to explain the crux of their disagreement, and each reviewed his viewpoint. After hearing their views, Jordan responded, “I have some good news and some bad news for each of you. There is some validity to what each of you said, but there also are some errors in each of your explanations. Jack tends to support the traditional approach to portfolio management; David’s view is more supportive of modern portfolio theory.” Just then, the company president interrupted them, indicating that he must talk to Jordan immediately. Jordan apologized for having to leave and made an arrangement to continue their discussion over a drink later that evening.
a. Analyze Jack’s argument and explain to him why a mutual fund investment may be over- diversified and that one does not necessarily have to have hundreds of thousands of dollars in order to diversify adequately.